Further evidence of tightened lending conditions and a potential credit crunch can be seen in the notable decline in demand for credit by large and middle market firms, a new survey of loan officers from the Federal Reserve shows.
Roughly 56% of loan officers noted a decline in demand for loans by large and middle market firms, while 53% reported a decline in credit demand by small firms.
This decline will affect the real economy in the near term as investment, hiring and growth slow on the back of tighter lending.
Roughly 56% of loan officers noted a decline in demand for loans by large and middle market firms, while 53% reported a decline in credit demand by small firms, according to the Fed’s quarterly Senior Loan Officer Opinion Survey released Monday.
Just over 45% of lending officers reported reducing the maximum size of credit lines to large and middle market firms, while nearly 63% reported that they raised premiums for lending.
Tighter loan covenants and increased collateral requirements will characterize lending to large and midsize firms, according to the survey. Those requirements all jumped noticeably for smaller firms, which will pull back on economic expansion immediately based on the data in the survey.
Approximately 46% of loan officers reported a tightening of lending standards for commercial and industrial loans for large and middle market firms, while 47% indicated a tightening in lending to smaller firms.
Tightening lending standards did not jump to levels observed during the pandemic. But they have been increasing for the past year, and the large decline in demand for credit among firms of all sizes indicates that the Federal Reserve’s efforts to cool the economy are bearing fruit.
Perhaps more problematic for local and regional banks—which make 70% of commercial real estate loans—was the tightening in that ecosystem.
While banks have been tightening lending standards for the past year, the jump in those reporting further tightening denotes an increase in the risk of a hard landing for the economy.
Nearly three-quarters, or 73.8%, of respondents reported a tightening of standards for construction and land development loans, 66.7% for nonfarm nonresidential structures and 64.5% for multifamily residential structures.
Not surprisingly, loan officers noted a 67.2%, 73.8% and 72.6% decline in demand for loans across those respective sectors.
Economic implications
Recent turmoil among local and regional banks has become a crisis of confidence among investors.
Increased regulatory oversight, falling equity valuations and compressed net interest margins all will most likely cause banks to pull back further on lending.
The primary implications of the Fed’s lending survey are that the cost of capital is increasing, which will dampen investment, hiring and growth.
Such moves in lending tend to show up 90 to 180 days following the imposition of restrictive credit conditions. Since the tightening started in March, we should observe an impact in the real economy this summer beyond anecdotal data discussions that we are already having with our clients and bankers.
The Federal Reserve’s survey shows a continued reluctance to borrow or lend in the first quarter.
In addition to the turmoil in the banking sector, this reluctance is a direct effect of the shift in monetary policy that raised the cost of overnight lending from 0.25% to 5.25% in just 14 months. It also signals the probability of an economic slowdown as business and residential investment declines and consumers pull back on spending.
Insuring against default risk
Congress’ reluctance to raise the nation’s debt limit could not have come at a worse time. The economy is showing signs of vulnerability, with the exception of the labor market, and a financial crisis would push it into a recession.
One measure of the perceived severity of the crisis is seen in the dramatic spike in the cost of a credit default swaps.
The CDS market is a vehicle for passing the increased risk of corporate default onto another party more willing to take on that risk. For instance, a business lender might consider that the interest rate on existing holdings is no longer adequate compensation for the increased risk of an economic slowdown and the increased risk of default by corporate borrowers. The CDS market offers additional insurance for that risk.
As we show, the cost of the one-year CDS is substantially higher than the three-year contract, implying a greater risk of default within the next year than in the next three years.
The takeaway
The risk of a pullback in lending is rising. Demand for loans and tightening credit standards will cause growth to slow as firms face rising costs of capital that supports productivity-enhancing investment and hiring.
Recent turmoil in the banking sector and a looming debt ceiling crisis are the primary reasons why we lifted our estimation of the probability of a recession to 75% over the next 12 months.
This data supports that forecast and denotes a rising risk around the economic outlook linked to tightening financial conditions.
If lending conditions continue to tighten along the lines implied by this survey, the economy would do well to generate 1% growth in the second half of the year.
