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TCH’s Take on the Business Loan Growth Conundrum

Posted 01/05/2018 by Francisco Covas and Bill Nelson

Recently the WSJ wrote an article “Business-Loan Growth Fell Off a Cliff in 2017 and No One Can Figure Out Why,” which raised an interesting and important question on the causes underlying the sluggish growth of commercial and industrial (C&I) loans at banks.  This phenomenon is illustrated in the chart below that plots the year-over-year growth rate of C&I loans at large banks since 1996.  In particular, the slowdown in C&I loans on banks’ books becomes more pronounced at the end of the first quarter of last year.

The Clearing House

 

In this post we argue that are two main reasons underlying the sluggishness in C&I loan growth:

  1. Weaker loan demand driven by recent increases in short-term interest rates and substitution between bank loans and corporate debt.
  2. Still tight credit conditions for riskier firms and small businesses which are the by-product of post-crisis reforms, including the interagency guidance on leveraged lending, U.S. stress tests, and the U.S. G-SIB surcharge.

At the end of the post we also provide some observations on the likely impact of changes in the tax code on the outlook for business lending.

Weaker loan demand

An important driver of the slowdown in C&I loan growth is weaker loan demand.  In each of the April, July and October 2017 Senior Loan Officer Opinion Surveys (SLOOS), many banks reported weaker loan demand.  The reasons cited for the reduced demand were widespread across various type of funding needs (to finance inventory, M&A activity, etc).  That said, business inventory growth has risen recently and that is expected to strengthen the demand for business loans in 2018.

Meanwhile, in the SLOOS several banks also cited substitution to nonbank sources of funding as a reason for weaker loan demand and corporate bond issuance remained robust throughout 2017 as shown in the chart below.  This indicates that the slowdown in C&I loans on banks’ books is also driven to some extent by a substitution from bank loans into corporate bonds.  As a result of the rise of short-term rates and the expectation that the Federal Reserve will increase short-term interest rates further this year, corporations turned to the bond market to secure funding at what are still relatively low interest rates and have likely used some of those proceeds to pay down some of their outstanding C&I loans.  Indeed, there has been an especially sharp slowdown in C&I loans at the branches and agencies of foreign banks, which tend to lend to large corporations that also typically issue corporate bonds.

 The Clearing House

A similar phenomenon may have happened during the so called “taper tantrum,” or the Fed’s tapering of asset purchases in 2013.  The Fed’s announcement caused U.S. Treasury yields to surge and, as shown in the loan growth chart shown on shown at the top of the post, there is a slowdown in C&I loan growth from approximately 10.5 percent to 6 percent between May and December of 2013.

Although weaker loan demand driven by the rise in short-term interest rates likely explains a significant portion of the recent slowdown in C&I loan growth, there are other important reasons for the slowdown that we discuss in the remainder of this blog post.

Still tight credit conditions for riskier firms and small businesses

While C&I loan growth was rapid over 2014 through 2016, we argued in a blog post early last year that the growth simply reflected a recovery from post-crisis lows.  At the time, several pointed to that rapid growth as evidence that tighter regulation and supervision was not curtailing credit availability.  Our view then, and our view now, is that the underlying trend in C&I loan growth has likely been reduced by overly stringent regulation and supervision, and the current low growth is, in part, a convergence to that trend as the economy has reached a new equilibrium.

The remainder of this section describes three main channels in which regulations are likely to be restraining the growth of business loans.  First, as shown by two recent academic papers available here and here, the interagency guidance on leveraged lending reduced leveraged lending at large banks and triggered a migration of such lending to nonbanks which are not subject to the guidance.  These two papers use different data sources and methodologies but arrive at the same conclusion that the leveraged lending guidance reduced originations of syndicated loans by banks.

Second, as shown by TCH’s bank conditions index the level of capital held by U.S. banks is at very high levels.  The increase in regulatory capital has been in large part driven by the U.S. stress tests and the capital surcharge for systemically important banks.  Because the Fed’s stress test is based exclusively on bank performance in a deep recession, banks subject to the tests have an incentive to substitute away from cyclically sensitive lending such as to speculative-grade firms, small businesses and households with less-than-pristine credit histories (in order to pass the test), and banks subject to the tests have indeed shifted away from small business loans.  In particular, we estimate that capital requirements for small business loans are approximately 4.5x higher under the Fed’s supervisory models in the U.S. stress tests relative to the Basel III Standardized Approach (SA).

The chart below shows the tier 1 capital requirements for small business loans under the current U.S. capital regime.  As depicted by the leftmost bar, banks need to hold on average $8.5 in tier 1 capital for each $100 of small business loans held on their books under the Basel III SA.  The solid bar to the right, denotes the amount of tier 1 capital a bank must have to pass the U.S. stress tests.  Specifically, under the Fed’s own models in DFAST, banks need to hold $38 in tier 1 capital for each $100 of small business loans on their books.  The significantly higher capital requirement reflects the severity of the supervisory macroeconomic scenario in the U.S. stress tests.  Generally, small businesses are typically considered to be riskier borrowers and banks’ expected losses rise abruptly during the horizon of the stress tests under the assumptions embedded in the supervisory stress scenario.

The Clearing House

Finally, another likely important reason the largest banks are not making more loans is the G-SIB surcharge.  As pointed out in a recent blog post, several of the largest U.S. G-SIBs are very close to crossing into the next G-SIB surcharge bucket which would result in a 50 basis point increase in the capital surcharge.  As a result, a significant expansion of lending and balance sheets would move some G-SIBs to the next capital surcharge bucket.  Notably, the slowdown in C&I loans was slightly more pronounced for large domestic banks at year-end, which is the quarter that matters the most as capital surcharges are calculated using year-end balance sheet data.

A few observations on the relationship between the U.S. tax-code overhaul and business lending

The U.S. tax-code overhaul is likely not going to have a major impact on business lending in the near term.  On the one hand, because interest payment on debt can be deducted from profits, the decline in the corporate tax rate reduces the incentive of corporations to use debt instead of equity to finance investments.  All else equal, this mechanism should dampen the demand for business loans.  On the other hand, the reduction in leverage caused by the decline in the corporate tax rate will lessen debt overhang problems – which occur when firms cannot borrow more funds to finance projects with a positive net present value because they already have too much debt – and increase investment and the demand for bank loans to fund such investment.  The combination of these two effects will likely lead to stronger loan demand, however it is not expected to be a key driver of business lending in the near term.  Moreover, if changes to the tax code boost aggregate demand it should also be expected to increase the demand for business loans.

 

Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.

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