What Increased Economic Cyclicality Means to Banking

In recent posts I’ve argued that the coming economy will be more variable than it was during the formative years for current business leaders. (See "Economic Volatility: Expect More Business Cycles Than You Are Used To" and "Recessions: How Severe and How Frequent in the Future?") What does this renewed cyclicality mean to banks? Greater loan losses, more balance sheet variability, and some human resource challenges.

As the economy booms and then busts, banks will have more credit quality issues. Not more issues relative to this past recession, but certainly more credit problems than in the 1983-2007 era. Although average economic conditions may be comparable to the past, banks don’t much benefit when borrowers enjoy a boom, but banks certainly take losses in the bust.

In the immediate future, though, high credit standards will mitigate this impact. In a couple of years, however, with the economy looking better, credit standards will drop back down to a more normal level. More businesses will be able to show two or three years of profitability. That’s exactly when the New Cyclicality will strike banks. Although it’s impossible to pinpoint the date of the next recession, there’s a good chance that the recession will hit just as we start to feel good again. The Great Recession will be a memory. We’ll figure that we’re done with that. Then the next recession will surprise us.

Bank managements also need to prepare for greater balance sheet variability. Loan demand depends not only on the bank’s marketing and sales efforts, but also on the economy. Real estate development has always been cyclical; that’s nothing new. Commercial loans are cyclical, with strong growth about two years after a recession is over. That rebound demand for commercial loans will be more prominent in the coming decade. Commercial real estate loans will also show the boom-bust pattern, as companies try to gain financial power when the economy is strong, only to hunker down as the economy slows. Consumer spending, too, is cyclical. In short, loan demand will rise and fall more sharply than it did over the past 25 years.

The deposit side of the balance sheet will also be more volatile, though not precisely aligned with the cycles in loans. The Federal Reserve will bounce back and forth between easing and tightening. Bank core deposits constitute over 80 percent of the money supply, so banks cannot avoid getting pushed or pulled by Fed policy.

When recession hits, the Fed will typically increase the money supply, propelling bank core deposits up. But in the late-recession, early-recovery stage, the rising deposits are not matched by loan volume. Banks may wonder why they are taking in all those deposits. After the economy gains steam, commercial lending rebounds. At this point, however, the Fed feels less need to stimulate, so the loan demand is not matched by deposit growth. Over the course of several business cycles, this see-sawing of loans and deposits will demand greater flexibility in balance sheet management.

Finally, banks compete with the rest of the economy for labor and other resources. When other sectors are booming, they may attract some bank employees. People whose skills are very specific to banking will be least affected. However, entry level tellers, information technology specialists, and a variety of other staff personnel may be lured away from the bank when other industries are booming. It’s important to develop great retention and recruitment programs well before those other industries take off.

The New Cyclicality will hit banking along with the rest of the business community. The key to managing in the new environment is thinking ahead about the challenges that will come with more business cycles, and adjusting policies and processes well ahead of time.