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.
A few years ago I posted a book review of Competing on Analytics. I've periodically harped on the subject of tracking and analyzing data. A good summary of future trends on the subject was recently prepared by Thornton May, writing for the CIO Leadership Network.
One of May's key points: "Migration from focusing on the past [what happened] to using predictive analytics to shape/influence what happens in the future."
If this topic is not high on your priority list, then I suggest revisiting your priorities.
"Trade wars" proclaimed recent headlines. Here's a guide for what business leaders should know about the controversy. There are two battle tactics to understand: exchange rate devaluation, and tariff/quota policy.
The U.S. dollar exchange rate has been falling, while other countries also want their own currencies to fall. However, it's clearly impossible for every country's exchange rate to fall. When one exchange rate falls, the trade partner's exchange rate rises. The easiest way to understand the dollar's exchange rates with many different countries is to average them, using weights based on how much trade we do with each country.
Why would a country want its exchange rate to fall? A falling exchange rate stimulates the economy. First, exports are more affordable to foreigners when the dollar is cheap. Second, our own consumers and businesses find buying American products more affordable than imports when the dollar is cheap. There's no doubt that the falling dollar by itself is stimulative, however there have been times when the factors that trigger a fall in an exchange rate are disastrous for the economy. But for the United States right now, a falling dollar is good for the economy.
However, the common view that governments can manage their exchange rates is misleading. If the Treasury starts selling dollars and buying Euros or Yuan, that would seem to push down our exchange rate. However, if the dollars simply come from our own economy, the private sector players will trade until they get their dollar holdings back where they want them. This "sterilized" intervention in foreign exchange markets has no lasting effect.
However, if the Federal Reserve prints up new dollars to be sold to foreigners, then the exchange rate declines. Yet, if the Fed prints up new dollars and distributes them to Americans, the dollar exchange rate also declines. It turns out that the only effective way to push foreign exchange rates around is to increase or decrease the country's money supply.
What's happening in today's trade wars is countries want lower exchange rates, and if they will print up enough of their currency, they can get them.
What happens if all countries print more money? Initially the world economy booms. Then it hits limits to productive capacity, at which point all the global currency becomes inflationary. (That's a bit of a simplification, but the gist of the story is accurate.)
Given the weak state of the advanced economies, it makes sense for them to increase their money supplies, pushing down their exchange rates. The major country this does NOT apply to is China, which has very strong growth. It makes sense for them to tighten up monetary policy, allowing their exchange rate to rise--just as the Obama Administration is jawboning them to do.
The Chinese should pursue a rising Yuan policy because it's good for them. It's also good for us, but that doesn't sell very well back in Beijing. Chinese policy has subsidized their own manufacturers and AMERICAN consumers, at the expense of U.S. manufacturers and Chinese consumers. Now it is time for them to reverse that policy.
The second battle tactic in a trade war is raising tariffs and quotas on imports. This is "beggar thy neighbor" policy, which aims to make the other guy worse off. If everyone does it, the whole world economy shrinks. It may sound good to "protect American jobs," and it may help some readily identifiable workers, such as steel workers. The cost, however, is to force Americans to pay more for the goods they buy, both imported goods as well as domestic goods that compete with imports, or even domestic goods that use in the production process imported goods. This kind of trade war is disastrous for the whole world. Google "Smoot Hawley tariff" to learn more.
Business Planning Implications: Businesses that are heavily involved in international trade should pay attention to this issue. That includes companies that buy or sell from other companies involved in international trade. (Example: you are a manufacturer; you buy components from other U.S. countries, but your suppliers buy from foreigners.)
Expect the United States to push our foreign exchange rate down versus the Yuan and the exchange rates of relatively strong economies. However, Europe and Japan may be in the same boat as us, and it's hard to say which countries will push harder for exchange rate devaluation. It could go either way. Time for some contingency planning for a fast-moving exchange rate.
On the tariff/quotas issue, stay tuned to Washington policy. This is, as much as I hate to say it, a time to keep paying your lobbyists. The worst outcomes often befall the companies who are not at the table when stupid foreign trade policies are adopted.
I like to scan the surveys of economic forecasts, including the Wall Street Journal's, Blue Chip Economic Indicators, and the Philadelphia Fed's Survey of Professional Forecasters. Lately I've been looking at how pessimistic the most optimistic forecasters are.
For example, Kurt Karl at Swiss Re has the most optimistic 2011 forecast, as reported in Blue Chip. Here's a comment he recently made:
"The risk of a double-dip is still only 10%."
I concur with Karl, but I have trouble saying "only" 10%. That's a pretty large risk.
Do you have life insurance? Your risk of dying this year is less than 10% if you are under age 85 (males) or 87 (females).
Does your business have fire insurance? The odds of a fire are less than 10%.
We make efforts to mitigate risk with respect to many low-probability events. For a risk of about 10%, it's time to do some contingency planning. I have an old blog post with an audio track that outlines my four-step process for economic contingency planning.
I am not forecasting a double-dip, but I certainly recognize the possibility.
A number of businesses have formed customer advisory boards to help better understand customer needs and opportunities. A common approach: have a get together, discuss business, play golf.
One of my clients added an extra-value benefit: an economics presentation including an interactive discussion on how to re-optimize businesses for a more cyclical economic environment. The discussions were excellent, and the participants walked out with actionable steps for their businesses, a win-win all around.
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