All good things must end—and someday, perhaps soon, the 10-year-old US economic expansion may run out of steam. Next month, it will become the longest boom in US history. Executives are well aware that the party might end. But not many have paused to consider what happens after the economy tips into recession. How bad will it be? And how can companies prepare for and manage a downturn?
Our colleagues have explored these questions for the macroeconomy, and we have done the same for a much narrower slice that is at particular risk: the US banking industry. Depending on the scenario that triggers the recession (for example, a slowdown in China, perhaps triggered by a trade war), a moderate or severe recession might result. Our research suggests that industry-wide losses might range from $117 billion in a moderate downturn to $435 billion in a severe recession.
Consider what might happen in commercial real estate (CRE), one of the industry’s biggest exposures. Across the six scenarios we modeled, including the Federal Reserve’s CCAR tests and multiple commercially available outlooks, banking industry losses might range from $27 billion to as much as $58 billion. CRE has mushroomed in recent years; total CRE lending (by banks, insurers, and others) is the highest it’s ever been, at about $2.2 trillion, up from $1.6 trillion just before the global financial crisis. Banks account for about $1.3 trillion of all CRE lending. Their CRE loan books have expanded by 2.4 percent annually since 2010 and have grown about 30 percent in the past decade. Meantime the rates of charge-offs and loans transitioning into delinquency are moving into historically low territory.
Success can breed complacency, of course, and the worry is that lenders will not pause until it is too late, creating significant impairments for individual institutions. Of particular concern are smaller banks (those with less than $10 billion in assets) and regional banks (up to $100 billion). Small banks’ CRE assets grew by 26 percent from 2008 to 2017; regional banks’ CRE holdings grew by 52 percent. This rapid expansion has lifted the CRE portion of small banks’ total assets from 20 percent to 25.3 percent; at regional banks, the CRE book now accounts for 18 percent of the total, up from 12 percent in 2008.
Similarly, some regions seem already to be nearing a peak, creating the potential for greater exposure for lenders. Multifamily prices in San Francisco grew only 1.9 percent in 2017, much slower than the 8 percent annual uptick that the city has enjoyed since 2000. A similar slowdown took place in New York City: 5.9 percent price growth in 2017, compared with 10.7 percent annual growth since 2000. As banks keep lending into the shifting environment, the newest loans with the longest maturity will be most at risk.
Corporate and industrial lending (C&I) is another asset class we’re watching closely. Loan balances have grown 4.1 percent annually since 2008, to $2.3 trillion today. That’s about 80 percent higher than the pre-crisis peak. Depending on scenario, and on lenders’ portfolios, banks could see significant losses, with sectors such as retail and oil and gas firmly in the crosshairs. Total losses in this asset class, which we estimate could range from about $15 billion to about $85 billion, would be second only to credit cards. In fact, because of the strong growth in lending books, losses in even a moderate recession would reach levels similar to the global financial crisis.
Even if a bank has managed its CRE and C&I exposures well, or its balance sheet consists mainly of other assets, it is still at risk. Our research also explores the dynamics of contagion risk. In downturns, correlations between asset classes approach 100 percent, and unexpected links can emerge. No one knows, for example, how the vast and growing stock of student debt will behave in a crisis, and whether defaults here will lead to defaults in other asset classes.In our forthcoming paper, we explore the dynamics of each asset class under a variety of scenarios and offer ideas for banks on how to prepare. The short version? Banks must get better at using new analytical tools to anticipate trouble; strengthen the balance sheet through both big portfolio moves and tactical changes; and preserve income through greater efficiency. When losses start to appear, banks need to mitigate them through better underwriting, a reinvigorated collections approach, and smart hedging. Throughout it all, they need a leadership mindset to gain advantage over competitors. No one comes through a recession unscathed, but history teaches us that the best banks dramatically outperform the worst and set themselves up for greater success when the cycle turns again.