Is weaker loan demand a bad omen?

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WASHINGTON — Banks appear to be increasingly skittish about making loans as credit quality is weakening in some areas. But experts are divided about whether recent signs of a cooling lending environment are a footnote in an otherwise strong economy, or a harbinger of things to come.

The economy continues to add jobs amid uncommonly high numbers of job openings. While stock market indexes suffered a two-month decline that ended in late December, they have largely rebounded in the first month and a half of the year.

Yet recent Federal Reserve data points to banks being tentative about the lending environment in 2019 while taking note of emerging signs of trouble on their balance sheets. Last week, the Fed's quarterly survey of senior loan officers found a startlingly precipitous decline in bankers’ expectations for loan demand across a range of categories. It was followed by a report from the Federal Reserve Bank of New York suggesting that credit markets are overextended and that default rates on auto loans have spiked.

But reactions to those recent indicators are mixed.

William Lee, chief economist at the Milken Institute and former head of North America economics for Citigroup, said the pessimistic tone regarding loan demand from the Fed's loan officer survey could be because it was conducted in late December and early January — precisely when markets were hitting bottom and economic uncertainties were most acute.

“In that environment, banks — as well as credit markets — were starting to be concerned,” Lee said. “Now, in the first quarter, I’m sure if we redo the senior loan officer survey today … the reaction would be slightly different, in the sense that the mood of pessimism seems to have washed itself away.”

But Gregory Daco, chief U.S. economist with Oxford Economics, said that it is just as likely that the survey uncovered not only banks’ true worries about underlying credit quality but also about near-term economic prospects.

“If you look at the underlying reasons that are listed as to why banks are tightening standards, for instance, it doesn’t seem to me that this is all cyclical. In an environment where growth is falling, you’re going to be less tolerant of risk-taking than in an environment where growth is accelerating,” Daco said. “If you were going to compare 2017 to 2019, tolerance for risk is going to be lower.”

Economic indicators have been sending mixed signals for months.

Despite the stock market rebound and job growth, there are hazards in view as well. The Chinese and European economies have been slowing dramatically in recent months, which could cool demand for U.S.-made products and raw materials.

A discrete disruptive event — for example, a no-deal Brexit or an escalation in the yearslong trade war between the U.S. and China — could also do swift and lasting damage to the global economy. The missed paychecks for furloughed workers affected by the recent government shutdown did not help the economic outlook.

The Fed's senior loan officer survey found bankers predicting weaker loan demand in 2019 — compared with the previous year — across many categories.

Of the 95 banks surveyed, almost half expected demand for construction and land development loans to weaken, while almost a quarter expected weaker demand for commercial and industrial loans from large firms and almost 20% expected a decline from smaller borrowers.

The respondents' outlook on credit quality was milder but still showed trouble signs. Nearly 27% expected tighter credit standards for commercial real estate loans, while 23% expected tighter standards for loans secured by nonfarm, nonresidential properties.

"Banks reported expecting to tighten standards for all categories of business loans as well as credit card loans and jumbo mortgages," the Fed said in releasing the survey. "Demand for most loan types is expected to weaken, on net, with the one exception being credit card loans, for which demand is expected to remain unchanged. Meanwhile, banks anticipate that loan performance will deteriorate for all surveyed categories."

Jaret Seiberg, an analyst at Cowen Washington Research Group, said in a research note that while the data suggests loan growth will take a hit in 2019, the expectation of tighter credit standards "also suggests banks are avoiding the pitfalls that lead to large credit losses."

"This survey paints a picture of a banking industry that is tightening underwriting standards in the face of weakening loan demand," Seiberg said. "That may be negative for loan growth, but it suggests banks are not setting the stage for credit losses by taking on more risk to maintain volume."

But higher loan losses could also be on the horizon. The New York Fed's Household Debt and Credit Report found that almost 5% of all auto loans are more than 90 days delinquent — the highest default rate in seven years — and that a growing proportion of the subprime auto market is held by big banks.

The New York Fed's report also found that household debt grew to a record high in the fourth quarter of 2018, to $13.54 trillion, reversing years of household deleveraging after the 2007-2009 financial crisis. Much of that debt is nonhousing debt, the report said, such as auto loans, credit cards and student loans.

Yet even if banks are being choosier with their lending activities because of dimmer economic prospects, that does not necessarily mean that credit is unavailable.

Lee said private equity and venture capital firms are increasingly playing a bigger role in helping businesses develop their product and grow — in fact, the number of publicly traded businesses has been declining for decades. Banks are taking on less risky aspects of business lending, he said, such as extending credit lines to existing businesses or even buying debt originated by nonbanks.

“Banks really have a very different role in terms of who they lend to these days than they used to, and that’s the strategic change in the sector that banks have to deal with,” Lee said.

When lenders tighten their standards and say no to borrowers, Lee said, it has the most pronounced effect at the lower end of the scale, such as small-business lending. Banks might choose not to make those loans, he said, but that isn't because of the economy — it's because of a structural shift toward bigger loans.

"You find that banks are trying to make big loans more often than small loans,” Lee said. "The size of loans has increased, especially post-Dodd-Frank … and even the small banks have started to give bigger loans. So small businesses in some ways are getting boxed out."

Daco said that if banks are tightening their standards, it can be a leading indicator of tighter credit conditions across the economy. But if banks are right — or at least they were right late last year when the SLOOS was being conducted — and the economy is cooling off, their best strategy is not to stop lending, but to manage the risks in the loans they do make.

“If a slowdown in credit growth, from a bank perspective, comes from a slowdown on the demand side … you’re going to be pickier, but that doesn’t mean you’re not going to be lending at all,” Daco said. “If anything you’re going to want to lend more, but take on less risk.”

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Credit quality Commercial lending Delinquencies Auto lending Policymaking Federal Reserve Federal Reserve Bank of New York
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