BID® Daily Newsletter
Jan 30, 2023

BID® Daily Newsletter

Jan 30, 2023

Preparing for an Economic Downturn

Summary: Economic forecasts for 2023 include a soft landing, stagflation, and recession. No matter which proves to be accurate, CFIs should prepare for the worst by assessing and taking steps to effectively manage risk.

In the 1960s, science fiction writer Arthur C. Clarke made predictions about life in the far distant future: the year 2000 and beyond. He envisioned a world in which satellites would make it possible for people to communicate instantly and remote work would be common. Clarke also anticipated that homes would be fueled by compact power sources that eliminated the need for power lines and other tethers to Earth. As a result, it would be possible for houses to float any location on Earth. (Clarke didn’t address how that might affect mortgage loans or insurance.) While he was right about communications, Clarke was wrong about homes.
Forecasting the future, even over the near term, is remarkably difficult. Today, with a hawkish Federal Reserve aggressively tightening monetary policy, economists, businesses, and community financial institutions (CFIs) are trying to predict whether the Fed can slow economic growth without leading the nation into recession. At the end of 2022, forecasts for economic growth in the US varied widely. Economists and surveys predicted that one of three scenarios would come to pass:
  1. A soft landing is possible. In November 2022, Goldman Sachs Chief Economist Jan Hatzius forecasted a 35% chance of recession in the US in 2023. However, Hatzius says there is a narrow path that would lead to a soft landing. A soft landing occurs when economic growth slows without contracting and then accelerates.
  2. We’ll be mired in stagflation. The majority of fund managers surveyed by Bank of America anticipate a year of above average inflation and slow economic growth. This combination is known as stagflation.
  3. A recession is coming. Bloomberg’s recession probability models from October suggest there is a 100% chance of recession in 2023. However, the publication’s December economist survey 70% of economists predicted a recession in 2023. Forecasts for the severity of a possible recession range from mild, with unemployment rising to 3.9%, to moderate, with employment rising to 4.2%.
Prepare for the worst, hope for the best.
Regardless of which forecast proves correct, it never hurts to prepare for the worst-case scenario. CFIs may want to start taking precautions to protect their institution in the event of a larger downturn, if they aren’t already. The Federal Reserve Bank of New York's quarterly report on household debt and credit showed that total household debt and credit are on the rise, and so is the share of debt that is becoming delinquent.
While delinquencies remain at historically low levels, many financial institutions have begun to set aside loan loss reserves in anticipation of recession. The four biggest banks in the US have set aside over $6.2B against future losses. In addition to evaluating reserve levels, CFIs are assessing risk and adopting risk management strategies by:
  • Stress testing assets
  • Tightening lending standards
  • Increasing loan loss reserves
  • Monitoring balance sheet interest rate risk
  • Hedging interest rate risk
  • Expanding other lending activity, such as credit cards and home equity loans
  • Offsetting potential lending losses with non-interest income
It may be advantageous to set aside reserves and take other steps to manage risk before a recession arrives. Institutions that build reserves early tend to continue lending through a recession, while those that delay may have to reduce lending. CFIs that remain nimble and liquid may have opportunities to improve net interest margins and loan-to-share ratios in 2023.
Despite an uncertain economic forecast for this year, CFIs have the opportunity to prepare for major shifts in the market. From stress testing their portfolio to making small changes to their loan strategies, a CFI can set itself up to weather whatever comes down the pipeline. Even if the landing this year is soft, it can never hurt to be in the most stable standing with your CFI’s assets.
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