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Volatile is not a big enough word to describe what’s going on in the global financial markets. Markets both reflect and anticipate their economies. Tariff wars, interest rates, global political instability – all have been cited as reasons to be nervous about the world economy and ours. But none are probably as meaningful to banks and their lending practices as the fourth leg of that stool, a slowing economy.
But the real economy data doesn’t look that slow. Some larger foreign economies are slowing. The U.S. is deliberately trying to reduce trade with them through tariffs, which is responsible for some slowing of our economy as well as theirs. China, the second largest economy in the world – first if you use a purchasing-power-parity based exchange rate – is trending downward, from 6.8 percent growth in GDP in 2017 to 6.5 percent this year to 5.8% projected for 2022. That’s not the same pace as the near 7 percent and more of the previous ten years, but neither is it slow in the long-run sense. In the U.S., the fundamentals remain strong. There is no underlying economic condition pointing to an inevitable recession.
Financial markets are disquieted by the political instability all around the world. But political instability does not necessarily create immediate economic dislocation. In the case of Brexit, for example, it’s been two years and now all the negative consequences that were predicted for a couple of years down the road look like they’re going to happen in March. The likelihood of avoiding a bad outcome, in terms of slowing British and European Union economies, looks less possible as deadlines approach and the political process does not seem to be coming up with plausible schemes to resolve the anticipated economic destabilization in any favorable way.
Of course, the U.S. government shutdown shows a political process that is dysfunctional, and that, too, worries financial markets. Blasting the Fed, for good reason or bad, really scares financial markets worldwide; Central Bank independence is key to financial stability. So there is a lot to suggest to financial markets that nothing good is going to happen in the near term to offset the bad things that are in store, even if all those bad things are basically political in nature and not about the otherwise fundamental soundness of the economy.
As well, if the Treasury secretary is worried enough about the chaos to make calls to major banks asking about their liquidity positions, that’s a worrisome development. That these calls are then made public was not reassuring.
So it seems we are in for a bumpy ride, even though we should be settling into a healthy growth path, if slower than last year, with essentially full employment and wages moving marginally higher.
This sort of situation is going to come up a lot in the years ahead, and points to an advantage of CECL over the incurred loss method of estimating allowances. The economy has been rather strong, so incurred losses are “normal” in the sense that even in the best of times there will be random shocks to firms which result in loan impairments. Actual losses are rather low, other than in some farm states where the tariffs are starting to bite, and many community banks have experienced no losses for several years.
It looks, however, that the risk to the good times is increasing. Forward-looking metrics, in particular the equity markets, are showing reason for concern. The debt markets are a little more complicated, maybe contrarian. The Fed is raising overnight interest rates and the two-year treasury is selling at continuously higher rates of return, suggesting that the debt markets aren’t looking for an economy that would require the Fed to ease rates over the next two years.
Mixed signals are not uncommon. But we have gone from a situation where the signals were mostly positive to a situation where some signals like the markets are reason for concern. If we were just looking at past experience, we would not be able to justify making any change in reserves. If we are looking at reasonable forecasts for the coming year, those forecasts are much more mixed than they were early this fall, and that change supports a more cautionary approach to forward-looking loss reserve allocation.
Tom Cunningham holds a Ph.D. in economics from Columbia University and was senior economist with the Federal Reserve Bank of Atlanta from 1985 to 2015. Mr. Cunningham serves as a consultant to MST in the creation and ongoing development of the MST Virtual Economist and is the MST Advisory economics specialist.
As employment is a key factor in projecting loan portfolio performance, current employment statistics and longer term trends are likely to be primary considerations for most banks and credit unions as they incorporate forward-looking economic factors in their ALLL estimations under the CECL accounting standard.
Under the new accounting standard, CECL, financial institutions will be required to consider economic factors in estimating their reserves. The MST Virtual Economist is an efficient, automated way to evaluate qualitative economic factors and project their impact on the institution’s loss rate, find new variables that impact the loss rate and determine the relevance of the economic factors you are already using to make qualitative adjustments. Click here for more information or to schedule a demonstration.
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