Will The Banks Drag The Economy Down?


Like a Depression-era hobo, the banking industry is clearly down on its luck. With real estate markets soft everywhere and more of their loans going bad, other commercial banks are sure to follow Bank of New England into insolvency. Pessimists are now predicting that the government will soon need to mount an S&L-style bailout of the commercial banking industry.

Even a string of bank failures, however, will not impedethe nation's recovery from what most forecasters see as a short and shallow recession. Indeed, the days when a banking crisis could drag down the rest of the economy are long past. The failure of an institution such as Bank of New England may be disruptive, but once the federal government has reimbursed the bank's depositors, it is no worse than a large company in any other industry going bankrupt.

The key reason: Commercial banks are no longer the main suppliers of credit to U. S. businesses and consumers. Nor are they the sole conduit between small savers and the capital markets (charts, page 30). Currently, banks make only 15% of all loans, down from more than 26% 10 years ago. Even that was below the one-third share they enjoyed in the 1960s and early 1970s. Notes George G. Kaufman, an economist at Loyola University of Chicago: "Commercial banks don't have the predominance they had 30 years ago."

Considering the weakened state of the banking industry, that's good news. In the past, banks occupied the central position in the U. S. economy, and economic activity rose and fell in rhythm with their fortunes, points out George J. Iwanicki, an economist at Kidder, Peabody & Co. They performed that bellwether role in 1969, for example, when commercial banks pulled back on lending and a recession followed a year later.

The banks and the overall economy no longer march in lockstep, however. Other lenders have broken the banks' hold on the market for debt financing. Large borrowers can now go directly to insurance companies, pension funds, and finance companies such as General Electric Capital Corp. Indeed, GECAP's $58.7 billion in assets made it more than twice the size of Bank of New England even before the bank failed. Borrowers also have direct access to capital markets through long-term bonds and short-term commercial paper. And as weak banks' funding costs rise, many borrowers can get better interest rates elsewhere.

As a result, while banks are exceedingly chary of their funds these days, credit hasn't dried up. Over the past year, the rate of commercial bank lending has fallen by 40% as the economy weakened and regulators increased their scrutiny. But 70% more commercial paper was issued in the third quarter of 1990 than a year earlier, going a long way toward making up the shortfall in bank lending.

Moreover, even small borrowers, which don't have direct and easy access to capital markets, aren't complaining of a credit crunch. According to a December survey by the National Federation of Independent Business, only 12% of small businesses reported that loans were harder to get than three months earlier. That's a figure barely higher than the one reported in June. By comparison, during the 1980-82 recession, about three times as many companies were reporting difficulty getting credit.

'MUSICAL BANKS.' True, bank troubles are putting the squeeze on commercial real estate developers. But with office vacancy rates pushing 20% in many large cities, that's no tragedy. Observes Edward E. Yardeni, economist at Prudential-Bache Securities Inc.: "We certainly don't want any more capital committed to commercial real estate."

One group that won't be hurt by the troubles in the banking industry, at least directly, is the depositors. The Bank of New England rescue operation shows that, at least for large banks, the government is still willing to make good on all deposits. With this protection, mass withdrawals from banks will be rare and short-lived. Moreover, some economists discount the dangers that bank runs pose to the financial system as a whole, since depositors are only moving their money from one institution to another. "It's a game of musical banks," says Kaufman. "What else can they do with their money?"

One thing they can do is put it into money-market funds, which are providing an alternative home for a growing share of deposits. But unlike hiding $10 bills under the mattress, that doesn't remove the money from the financial system. Like banks, money-market funds generate returns for their "depositors" by making loans. About half of their assets are in commercial paper. Even when the funds invest in government securities, their activities add money to the overall credit pool.

And while the money-market funds are showing themselves to be efficient recyclers of funds to credit markets, the banks, considered as an industry, look increasingly uncompetitive. From 1979 to 1989, which were both good years for bank lending, the amount of funds that commercial banks supplied to the credit markets fell by 16%, adjusted for inflation. Nevertheless, over the same period, their number of employees rose by 14%. A manufacturing company with productivity this abysmal would quickly have been overwhelmed by import competition. Instead, the banks didn't start making cutbacks in personnel or lending until their situation grew dire.

Although bank layoffs may cause local economic problems in places such as New York City, their troubles are not dampening the optimism of some economic forecasters. "It's hard to foresee things getting worse, now that the Fed is dedicated to providing liquidity," says Gail D. Fosler, chief economist at the Conference Board. Even after the latest bank failure, she's forecasting a rebound starting in the first quarter of this year.

Paradoxically, widespread problems among banks could accelerate the economic recovery. Faced with turmoil in the banking system, the Fed is moving swiftly to maintain the liquidity of the financial markets. "Once the panic becomes widely recognized," says Yardeni, "the Fed lowers interest rates very aggressively"--which should boost economic activity. In part, that's why Yardeni is looking for GNP to grow at a 1.8% annual rate in the first quarter. If he's right, the recession of 1990-91 may quickly become a nonevent.

'A WASH.' Even a run of bank failures big enough to deplete the coffers of the Federal Deposit Insurance Corp., requiring an infusion of more money to replenish the fund, shouldn't have major macroeconomic consequences. True, if the government borrows the money needed to bolster the banks, the budget deficit could rise considerably. But most economists agree that the money being borrowed to pay for the S&L bailout is not depriving the rest of the economy of funds. It's being used to reimburse depositors, who put it right back into the financial system where it can be lent out again. "From a macroeconomic standpoint, the thrift bailout is a wash," says Robert E. Litan, an economist at the Brookings Institution. And the same would be true of any large-scale rescue of the commercial banking industry.

To be sure, some economic forecasters see bank troubles, along with war in the Middle East, as the biggest risks that the economy faces. Kurt Karl, senior economist at WEFA Group, says more bank failures would make the downturn longer and deeper. Even so, by his calculations this would still be the mildest recession in the last 20 years.

Other economists worry that the credit crunch won't develop until the economy turns back up and companies start looking for loans again. But at a time when some people are laying out scenarios for a depression, the thought of having troubles in a recovery seems almost comforting.

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