The banking sector is structurally important for any economy. As many would recall, U.S. banks were hit badly during the 2008–2009 Global Financial Crisis, when the housing market crash pushed the economy into its longest recession since World War II. Many economists are now predicting a U.S. recession. Here’s what happens to banks during a recession.
Banks' core business is to borrow and lend money. Over the years, banks have diversified into several other financial businesses like stock trading, wealth management, and investment banking. During a recession, most banks' businesses are impacted.
Banks see a fall in business during a recession.
During a recession, the demand for new loans, both from individuals as well as companies, falls. This invariably leads to lower revenues for banks. Revenues from stock trading and investment banking also fall during a recession. We have already started to see signs of a severe slowdown in both these sectors.
The U.S. IPO market has literally dried up while merger and acquisition activity has also been tepid. Retail stock trading volumes have dipped, which was visible in Robinhood’s earnings.
Banks see higher loan losses during a recession.
During a recession, many individuals and companies aren't able to repay their loans. As a result, banks see higher loan losses during a recession. In 2020, U.S. banks had set aside billions of dollars toward loan loss reserves. Since the recession ended soon, banks released their reserves in 2021, which boosted their profitability that year.
There's an interplay between interest rates and recession.
Usually, the Federal Reserve lowers interest rates during a recession to provide support to the economy. However, things are different this time around and the Fed is actually raising rates. In a falling interest rate environment, banks see a fall in their net interest margins since they usually borrow for the short term and lend for the long term.
However, a rising rate environment in a recession wouldn't help banks as it would only increase the loan losses. Rising interest rates would make loan servicing even tougher for borrowers.
Is your money safe in banks during a recession?
Most people would recall the Lehman Brothers crisis of 2008. Most of the other U.S. banks were also hit hard by the economic turmoil. Eventually, the federal government stepped in and bailed out the banking system given its systemic importance.
Many wonder whether their money is safe in banks during a recession or if they are better off keeping the money in coffee cans, as in older times. However, if you have kept your money in an FDIC-insured bank you don't need to worry much.
FDIC offers deposit insurance at FDIC-insured banks, which automatically covers the deposits without the depositor having to pay for the insurance. According to the FDIC, “The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.”
Banking stocks are cyclical in nature.
The banking sector, and by its extension, banking stocks are cyclical in nature. Like all cyclical sectors, banks also see a rebound in business during an economic upcycle. However, during periods of economic turmoil, including a recession, banks see a slump in businesses.