More than 1.5MM metric tons of vinegar are used within North America each year. Since vinegar contains between 4% to 8% of acetic acid, it is a common ingredient in many food dishes, helping to bind ingredients together and provide acidity. Vinegar’s acidity in cleaning products helps kill certain bacteria, and it naturally breaks down grease, mineral deposits, and soap scum. Combined with certain chemicals such as bleach, ammonia, or hydrogen peroxide, however, vinegar can create toxic and corrosive gases that can lead to respiratory problems for anyone who inhales it.Much like the same substance can yield contrasting results in different situations, there are major variances in how the current economy is impacting different households and businesses. The US is currently in what economists describe as a K-shaped economy, where day-to-day financial realities differ drastically for various segments of the population and sectors — a reality that could prove problematic for many small businesses. Failing to understand the unique impact that the economy is having on specific portions of the population and businesses could lead community financial institutions (CFIs) to miss early signs of stress within vulnerable segments or to enact unnecessarily onerous credit tightening.Understanding a K-Shaped Economy Economists define a K-shaped economy as one where there is a massive divide between the experience of high earners, who benefit from a booming stock market, and lower earners, who struggle financially amidst rising inflation. The term was coined in 2020 by economist Peter Atwater, who used it to describe the extreme divergence in the impact of COVID-19, where many individuals and businesses recovered financially from the pandemic quickly, while others experienced long-term losses and financial difficulties. The current K-shaped economy is the result of ongoing impacts from high inflation, ongoing high interest rates that benefit asset owners yet harm individuals and businesses with debt, and even the rapid evolution of artificial intelligence. Further fueling current conditions is the rising amount of credit card debt within the country, coupled with a proposed 10% interest rate cap that could significantly reduce access to lower-income families and some of the people who rely most heavily on credit. Amidst such a stark divergence in the financial health of individuals and businesses, particularly small- and medium-sized businesses (SMBs), it is important for CFIs to understand the intricacies of this dichotomy. While many large businesses and high-income consumers are thriving and appear solid, the flip side, where small businesses and low- and middle-class households struggle with higher prices and weaker consumer demand, creates the risk of rising delinquencies for lenders. Unfortunately, the divide is only getting wider. According to the findings of a 2024 Pew Research Report, the middle class continues to shrink. Pew Research found that the middle class in America comprised 51% of the population as of 2023, down from 61% in 1971. CFIs should pay close attention to lending portfolios with high exposure to SMBs within interest-sensitive sectors or those heavily reliant on low- and middle-class customer bases that are being forced to pull back on spending by utilizing targeted monitoring for early signs of stress. The RisksA K-shaped economy creates multiple challenges for CFIs and SMBs alike. The following are some of the biggest risks and challenges that CFIs should be aware of:
- Borrower financial issues. Ongoing inflation and pricing pressures, compounded by the impact of the Iran war, mean individuals on the lower end of the K are having to rely more heavily on credit, and loan delinquencies are rising. Though small business delinquencies may be manageable for some lenders, a rising number of defaults are concentrated within particular geographic areas and certain industries. Red flags that SMBs may be experiencing difficulties include heightened use of revolving credit, short-term liquidity products, or a pickup in utilization of overdraft services. Not only should CFIs actively monitor for such red flags among SMBs, but they should also keep a close watch on data trends and risk indicators.
- Deposit volatility. Income disparities mean there will be more income and spending on the upper end of the K, creating the possibility of greater deposit volatility. CFIs will need to compete more aggressively on price to maintain deposit balances among this group to keep them from gravitating to larger financial institutions or fintechs able to offer higher interest rates.
- SMB cash flow instability. Smaller businesses catering to middle- and low-income communities are likely to experience slower growth. Since such businesses typically operate on very small margins, many of these organizations may struggle with cash flow issues and find it difficult to maintain adequate inventories or to hold on to key employees.
Helping Customers Weather a Challenging EconomySupporting customers who may be struggling in the current economy requires having a strong handle on which individuals and organizations are most at risk. CFIs should keep a close eye on the strength of SMB borrowers by actively stress testing portfolios that include these businesses, paying particular attention to rate structures, sectors, and geography. It is equally important to run scenarios that assume ongoing pressures. Beyond actively monitoring customer data, CFIs should check in with SMB customers to see if they are facing challenges that aren’t yet visible and to offer advisory services for things such as cash flow management and planning, scenario planning, and even assistance in right-sizing debt. Where possible, CFIs may also want to consider accommodations, including term extensions or refinancing floating debt that no longer matches cash flows. It is not only important for CFIs to understand the many risks created by a K-shaped economy, but to remember that there are areas where growth opportunities continue to exist. Having a good grip on the widening divide between struggling customer segments and those benefitting from the current economy can help CFIs identify the most important red flags, as well as areas where growth opportunities remain. A hands-on approach with customers and tailored services and offerings for both ends of the K, particularly SMBs, can help reduce the risk of losses and can help CFIs retain long-term ties to customers by setting themselves apart from larger financial institutions that are more likely to respond to heightened economic risks by tightening lending requirements across the board.
