U.S. banks are bracing for possible deflation and, if it comes, it will not be pretty for lenders, analysts said.
Atlanta-based SunTrust (NYSE:STI) has set up a special committee to assess its exposure to deflation, said Nancy Bush, an NAB Research analyst briefed on the matter by the company.
Birmingham, Alabama-based Regions Financial Corp (NYSE:RF) and Columbus, Georgia-based Synovus (NYSE:SNV) warned investors about the potential risk of deflation in regulatory filings earlier this year.
BB&T ran its books through a stress test to gauge the bank's performance in a scenario in which there is deflation for the next 10 years, as part of the bank's own internal projections of various economic scenarios, Chief Financial Officer Daryl Bible said in an interview.
"It'd be challenging. We think we could survive, but there would be definite impacts on revenue and earnings," he said. Other banks have likely performed these tests as well at the request of regulators.
A spokesman for SunTrust said in an email that the bank continuously evaluates a range of scenarios, including the impact of deflation, but he said the bank does not discuss these scenarios externally.
A little deflation in theory could help banks by increasing the value of the dollars they receive from borrowers for interest and principal payments.
But deflation can feed on itself: when prices start falling broadly, people and companies often put off purchases, reducing demand as they wait for prices to fall further, said Robert Albertson, chief strategist at Sandler O'Neill in New York.
The United States experienced such a deflationary spiral during the Great Depression in the 1930s, and Japan experienced one in the 1990s.
If deflation is widespread, it can be toxic for banks. As Japanese banks discovered in the last decade, deflation means that collateral values decline, giving a bank bigger losses on failed loans.
And loans may become more likely to fail, as borrowers tire of paying high rates of interest to finance assets that are worth much less than they had been previously. A second credit crisis could emerge.
"For banks, there's no good way out of deflation," said Bush, the NAB analyst.
Most banks and their regulators carry out "stress tests" for deflation, said Bill Isaac, chairman of LECG Global Financial Services and a former FDIC chairman.
Banks are likely already assessing various loans they hold to determine how they might perform if deflation strikes, Isaac said.
"It wouldn't be pleasant for the banking industry to have to deal with more deflation, it's already been difficult enough in the housing area," he said.
To be sure, deflation may never come. Even as unemployment remains high and consumer demand is low, the consumer price index does not seem to be indicating deflation ahead, Albertson said.
Albertson thinks historical comparisons to the Great Depression or Japan are misleading, since global demand -- specifically, from emerging economies that are growing rapidly -- could still increase prices for goods in the United States, even if demand in this country remains weak.
What's more, Federal Reserve officials have already signaled that they would be prepared to take action to prevent deflation developing.
But there is still a chance of deflation.
"I do not expect outright deflation to develop, but the slowing of the economy in the middle of this year, combined with a very low measured rate of inflation, suggests to me the risk of deflation cannot be dismissed," said Dennis Lockhart, president of the Atlanta Federal Reserve, at the end of last month.
Many analysts expect the Fed to launch a renewed round of bond buying, or quantitative easing, as soon as its next policy meeting at the beginning of November. A weaker than expected September employment report last week did not help matters.
But even slow growth is a difficult scenario for banks. Sluggish loan demand has already dampened bank profits this year. Shares in banks including JPMorgan Chase and Co (NYSE:JPM) and Wells Fargo & Co (NYSE:WFC) are each down 5% year-to-date, while the S&P 500 index is up 4%.
"If we don't see growth, you could see credit numbers go bad again," said Chris Whalen, co-founder of Institutional Risk Analytics. "That's going to mean a lot of banks losing money."