A number of us economists are very worried about the prospects of recession. Most of us are not actually forecasting a recession, but on average we figure the odds are about 30 percent that we’ll have a recession next year. What should banks do differently because of this risk?
Recessions have some common traits but also have twists and turns that make each episode unique. Bankers planning for 2012 should consider the greatest downside risk to come from the European financial crisis. Some parts of bank planning should reflect the general possibility of a downturn, and some parts should be specific to the European risk.
Recessions most obviously bring credit quality problems to banks but also changes in the balance sheet. Loan demand weakens during a recession. Certainly commercial lending demand would decline as credit-worthy borrowers hunker down. Although real estate lending usually falls in recession, current loan production is so small that there’s not a lot of downside in that category. Consumer lending is likely to fall as well.
Deposits typically grow rapidly as the economy pulls out of recession, thanks to Federal Reserve efforts to stimulate the recovery. This time round, however, don’t expect massive Fed policy changes, due to already-low interest rates and nervousness about the past Fed actions proving inflationary.
Now let’s turn to the credit quality problem. Banks should think about specific problems triggered by a European recession, as well as general weakness caused by the overall downturn. The first issue applies to companies that are selling a good bit of their products or services to European customers. Remember that foreign trades tend to be more cyclical than the overall economy, so if European spending falls by one percent, our exports to Europe could fall by two percent.
When assessing which companies have significant exposure to Europe, don’t limit analysis to the company’s own sales. Many businesses sell components to other businesses that end up being sold in Europe. So a company may have significant exposure overseas even if its largest customers are American corporations. Here’s another case where the importance of knowing the customer is central to credit quality.
After reviewing the companies that have European exposure, the bank’s credit officers should think about the impact of a recession more generally. Even if you are not banking the firms with the biggest European exposure, those businesses may be part of your community’s economy. For the United States as a whole, sales to Europe account for 22 percent of all exports. Despite our trade deficit, exports are a big deal to the overall United States economy, accounting for two trillion dollars of our 15 trillion dollar economy.
Your own state, however, may have a smaller or larger reliance on exports, and specifically on exports to Europe. For example, Utah has the highest exposure to Europe as a percentage of their economy, exporting about 5.6 percent of the state’s GDP to the Continent. Hawaii, on the other hand, exports less than 0.2 percent of its GDP to Europe. The statistics are not perfect, but they do give a general idea of a state’s risk. (See the chart showing state exports to Europe in the previous blog post.)
Despite all this talk about recession, a downturn is not the most likely scenario. The odds are that we will skate through. However, a risk this big must be addressed by bank leadership.
The greatest risk to the United States economy right now is a recession triggered by the European financial crisis. Even though my best estimate is that we will avoid a recession, the risk is certainly high.
I'm writing an article for bankers on this topic, and I wondered how much states varied in their exports to Europe. My own state of Oregon has a fairly high level of exports relative to GDP, but a relatively light share of its exports head to Europe. As a data guy, I did the obvious: grab some numbers and command Excel to do the long division. (Exports are from http://tse.export.gov/TSE/TSEHome.aspx, and GDP comes form http://www.bea.gov/)
The data are not perfect, but they do give a general idea of how high each state's direct risk from Europe is. I say direct risk because there's also indirect risk: if a bunch of East Coast states go into recession, the West Coast can't avoid it even though their direct exports to Europe are small.
This weeks marks the 150th anniversary of two very noteworthy events.
On October 24, 1861, the transcontinental telegraph was completed as the line from Carson City was connected in Salt Lake City. The prior week the line from Omaha had reached Salt Lake.
The second major event of note was the closing of the Pony Express on October 26, 1861, two days after the telegraph was completed. Now that's what Joseph Schumpeter called creative destruction. The act of creation triggered the destruction of a preceding industry.
The closing of the Pony Express cost about 80 jobs for riders, and over 100 express stations were closed, although the station-masters may have had other income in addition to their Pony Express work.
The telegraph industry at its peak had many more employees. I haven't found data on total industry employment, but one union of telegraph employees had 78,000 members at its peak.
It may be hard to see the benefits of new technology in terms of jobs, but trust me: if the new technology is truly valuable, the economy as a whole benefits and new jobs will be found in new industries.
The Businomics Newsletter for October 2011 was released earlier this week. There's a link on that page to subscribe for free. Here's the front matter, not included in the link above:
What’s New, October 2011
What’s different about the newsletter? Jacob Reiff won a copy of the Businomics book, being the first to observe that the title now includes “Connecting the Dots Between the Economy . . . and Business.” I added the tag line to help you remember that I help businesses with their strategy and planning.
Press Coverage: I’ve asked my assistant to keep the web page updated, so now it will get done reliably. Check it out if you’re interested.
A couple of sharp readers mentioned the growth of European deposits at United States banks. The European banks seem risky to some, and the FDIC now insures an unlimited amount of transaction deposits, so millions and millions of dollars flew across the Atlantic to take our safe haven.
What's the underlying trend of money supply growth excluding this hot money? One simple way to get an idea is to exclude non-interest-bearing accounts from core deposits. We call the non-interest bearing accounts Demand accounts. The other components of core deposits are interest-bearing checking, savings accounts and certificates of deposit less than $100,000.
Looks to me that the European hot money is a real phenomenon, but that the non-hot deposits are also growing rapidly, at a pace nearly as strong as in the wake of the Lehman Brothers bankruptcy. About one year after that surge of money supply growth the economy recorded its best growth of the recovery. There is reason to be optimistic that we have some genuine money supply growth now, which will help the economy in the coming months.
Mother Jones has a cool chart of bank mergers explaining how the big four banks (Citi, Chase, Bank of America and Wells Fargo) got where they are. (Click on chart for larger image.)
Consolidation has certainly shrunk the number of banks, BUT there have also been 2,315 new banks chartered in the past 20 years. (source: FDIC)
Here's what I tell bank executives on the subject: when the big guys are firing on all cylinders, they have a cost advantage over smaller banks. Size does help lower costs. However, they rarely fire on all cyclinders. There seems to always be some service failure in some part of a large organization. They have trouble digesting an acquisition, or a computer system conversion fails badly, or a key executive is too focused on golf and empire-building to ensure good customer service, or the CFO finds a new way to boost short-term earnings at the expense of long-term relationships.
When the big boys have a sick division, they don't heal very quickly.
In contrast, community bank management knows their problems immediately, because they know their customers much better. They usually fix their service issues quickly. If not, they lose market share quickly. Although smaller banks have higher cost structures, their quick self-healing balances their higher costs.
The mid-sized banks really have to be on top of their game. They don't quite have the economies of scale of the largest banks, but they have enough layers of management that problems may not be addressed immediately. On the positive side, they have the size to better capitalize on the weaknesses of the big banks.
In other words, there is a niche for all sizes of banks. And when the big banks fail to serve their customers well, there will always be a small bank (or credit union) ready to steal those relationships.
I'l be speaking to a class of MBA students this afternoon, and I'll begin by posing the following question:
You're CEO. Your division heads are preparing budgets and plans for 2012. You gave them guidance mid-summer, saying use a middle-of-the road view of the economy. And you gave them a link to a survey of professional economists. That survey showed an average forecast of GDP for 2012 of 2.6 percent, better than the estimated figure for this year, but not strong enough to make anybody feel good.
(There's good reason to use such a survey. Over time, averages of forecasts are better than any single forecaster. Also the Philadelphia Fed survey is free, which is a very good price.)
Now what do you do? In answering, note that the risk of recession is less than 50-50. Also note, however, that the risk is pretty big.
Note to reader: this is a good time to pause and think.
It doesn't make sense to base your plans on a recession whose probability is less than 50 percent, but neither can you ignore such a big risk. For a suggestion on how to handle this, read this blog post about recessions and business planning.
I sometimes hear that nobody ever dies wishing he had spent more time at the office. I bet that plenty of people die regretting the things they could have accomplished but didn't. Like, a guy who thought about making a personal computer, but lit up another doobie instead. The person who envisioned a library of downloadable music but thought computer programming would be too much work. Or the person who imagined a computer on a tablet, but couldn't work on it because Dancing With the Stars was on.
I hope that Steve Jobs had few regrets when he left us. He did so much that has improved our lives, even for those of us who are not Apple guys.
The renowned bond manager Bill Gross says that the global economy is at risk of recession.
What difference does the risk of recession make to your business plan? Here's a rough outline of what I tell my clients. (Feel free to call if you'd to be a client who gets more details.)
1) The risk of recession is not so high that it should be your base case for planning. It's hard to avoid the doom and gloom right now, but we tend to overemphasize the most recent news we've heard, and we tend to give too little credence to the tendency of economies to bounce back.
2) For each of your major action steps for the coming year, evaluate what difference the recession makes. For example, you may have two action steps associated with capital spending, one to add capacity at your mill, the other to install new software that will lower operating costs. Both are justified based on a moderate gain in sales. Now look at each through your recession lens. The capacity increase may not be needed in a recession. However, the cost-saving investment might very well make sense. Calculate savings at the lower production volume you would experience in a recession, and consider who tight working capital would be in a recession. You may find that some capital spending still makes sense even in a recession scenario.
Run this exercise for all major issues you have control over. Staffing levels, marketing plans, financial plans all need to be consisdered for both the normal levels and recession levels.
3) For action steps that will change if a recession does occur, develop a tracking system to monitor the best measure of your own sales. In some businesses, one tracking system may be adequate. However, if you are selling different products, in different regions, or through different channels, you may need several monitoring systems.
You may need to look through your customer to the ultimate user of your products or services. So if you are selling tray tables to Boeing, you need to think about the airlines around the world, not just Boeing's latest request for tray tables.
4) Use the data series in your economic tracking system to make check points. For example, you might decide that first quarters sales need to be $13.5 million, with total industry sales of $8.5 billion, for you to consider yourself on track. When first quarter data are in, if they don't match your check point value, then you shift to recession mode. Of course you don't need to set a rule that doesn't consider exceptions or extenuating circumstances. However, by setting up the rule ahead of time you will shorten your decision time if a downturn comes. Right now you have leisure to think of how you'll react to different scenarios. If we go into a recession, time will be in very short supply.
It's easy to complain about the politicians and to worry about the prospects for a new recession. If you run a business or a division of a corporation, you're getting paid not to complain and worry, but to navigate through whatever conditions the economy gives you. Get started incorporating the possibility of a recession into your business plans. Call me if you'd like some help.
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