Bank building
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Commercial banks have been reducing lending to businesses throughout 2023. The declines have been small and consistent with the flat trend in total lending of all kinds this year. The changes are not yet a reason to be pessimistic about the overall economy. But the economic uncertainty that is driving the changes is significant for both lenders and borrowers.
Since February 2023, commercial and industrial loans held by commercial banks have fallen by $33 billion. That sounds like a big amount, but it's only about 1%. Some bankers point to a decline in deposits as the culprit. “How can you lend if you don't have deposits?” they ask.
Decreasing bank deposits
They have a point. Total bank deposits have fallen by $313 billion since February 2023, or about 2%. But banks' loan-to-deposit ratios are now at 71%, down from 74% to 77% in the five years before the pandemic. A return to that 74% ratio would allow for roughly 18% growth in business lending.
But banks are feeling more pain than the decline in deposits suggests. Core deposits (total deposits minus large term deposits) have fallen by $1.1 trillion, or 6%, since February 2023. And the reality is even worse than this: Both checking and money market deposit account balances have fallen. Banks are filling the gap not only with large term deposits, but also with brokered small term deposits.
The Wall Street Journal reported that brokered CDs increased 86%. They are sold through brokerages and are typically sold to investors who are dissatisfied with their current interest income. Customers can easily buy CDs from multiple banks and get FDIC protection, even if their total deposits are large. The bad news for banks is that they are pretty expensive. Banks typically offer lower interest rates to customers who visit a branch. Loyal customers are usually less price sensitive than those who shop for rates online.
Bank lending margins remain strong
Returning to lending, the difficulty in acquiring deposits is costly for banks. But that’s only part of the story. The interest rates banks earn on loans are also rising. Total interest income in the second quarter of 2023 increased 72% year over year, even as loan volume increased by just 4%. Net interest margins, as shown in FDIC reports, rose from 2.80% to 3.28% over the last four quarters. The National Federation of Independent Business reports that its members who took out loans with shorter maturities paid an average interest rate of 9.1%. As of this writing, interest rates on short-term CDs are between 5.0% and 5.5%. So banks should be happy to make business loans, and industry-wide figures show that net interest margins are on par with historical averages for all but the smallest banks.
Bank credit standards have tightened
Banks tightening or loosening credit standards.
Dr. Bill Connerly, based on Federal Reserve data.
Credit standards are an important factor in bank lending volume. As the chart above, based on the Fed's Senior Loan Officer Survey, shows, banks are tightening credit standards more often than they are loosening them. Banks are also widening spreads, the difference between the interest rates they charge on commercial and industrial loans and the interest rates they pay on deposits.
A big concern for bankers who set credit standards is the risk of a recession. Two years ago, economists in a Wall Street Journal survey averaged a 16% chance of a recession, but more recently economists averaged a 48% chance of a recession, up from 63% a year ago. Anticipating a recession or worrying about its possibility likely led bankers to tighten credit standards.
Demand for corporate loans is declining
In 2023, demand for business loans remained flat.
Dr. Bill Connerly relies on data from the U.S. Census Bureau and the Federal Reserve.
The actual amount of lending reflects not only banks' willingness to lend, but also businesses' willingness to borrow. The three economic drivers of business borrowing are driving most of the demand: inventory, accounts receivable, and capital investment. As the chart shows, these have remained roughly flat over the past year.
The weak demand for credit is due in part to the economic outlook. When a recession is expected or feared, companies typically try to operate with low inventories. Capital investment may be weak if additional production capacity is not needed. Also, companies are tightening their own trade credit terms as they fear that accounts receivable may become uncollectible if the economy worsens.
Business loan demand forecast
The outlook for business lending appears to reflect broader concerns about an economic slowdown in 2024. The banking system has the capacity and, in most cases, the profit motive to lend more. As economic activity recovers, demand for credit will eventually follow. But for now, concerns about the future are limiting the economy. And they are real concerns. As I've previously reported, I still expect a mild recession to begin in early 2024.