Bank Lending to the Real Economy Has Stalled

Meanwhile, loans to nonbanks have doubled over the past five years

I’ve written extensively about the U.S. consumer economy, and occasionally about the contribution of bank lending to consumer spending and economic activity more broadly. The Federal Reserve (Fed) has written that changes in the federal funds rate affect other interest rates that in turn “influence borrowing costs for households and businesses as well as broader financial conditions.” The idea is that Fed rate cuts will lead to lower interest rates that will spur borrowing and spending, and that the opposite will happen in response to rate hikes. However, there are many hopes/assumptions embedded in that line of thinking. One is that borrowing rates for households and businesses will respond to the Fed’s rate moves in the direction that the Fed expects. Another is that banks will be willing and able to lend more to households and businesses if/when borrowing rates fall (large, investment-grade companies have access to the corporate bond market as well as to bank loans, but households and small businesses don’t have that luxury). Yet another is that households and businesses will be willing to borrow and spend more at lower rates, even if those lower rates reflect a deteriorating economy/job market.

Along the lines of those hopes/assumptions, the early returns on the Fed’s decision to cut the fed funds rate by 50 basis points last month have been suboptimal: the yield on the 10-year Treasury has gone from 3.7% to 4.24%, an increase greater than what the Fed cut the fed funds rate by. Largely as a result, the 30-year fixed mortgage rate as calculated by Mortgage News Daily hit 6.9%, up from 6.15% when the Fed cut rates. As the 10-year Treasury yield has risen following the Fed’s cut, borrowing rates for many Americans have done the same.

What about banks’ willingness and ability to lend more to households and businesses, and households’ and businesses’ willingness to borrow more? In the charts below, I compare the growth of bank loans to nondepository financial institutions (NDFIs) such as private credit firms, hedge funds and securitization vehicles to all other bank lending, based on H.8 data from the Fed (weekly, not seasonally adjusted). What’s apparent is that the growth in bank lending to NDFIs has dwarfed that to the real economy. In the last two years through the week of October 16, bank loans to NDFIs are up 24%, compared to all other bank loans up just 5%. From the end of last year, bank loans to NDFIs are up 7%, compared to all other loans that are essentially flat (up just 0.65%). Put another way, bank loans to NDFIs have accounted for half of all loan growth since the end of last year, even though such loans account for less than 9% of all loans outstanding.

One might argue that NDFIs such as private credit firms are lending to companies, such that at least some loans to NDFIs ultimately support the economy. However, there’s little data to support that argument. Per a Bloomberg article last week, “Private credit typically involved money managers lending to rivals’ portfolio companies that couldn’t readily tap public bond and loan markets. They were financing buyouts and dealing with businesses that were smaller and too leveraged for banks to touch.” Private credit firms are now “battling to establish credibility as plain-vanilla lenders” to investment-grade companies, but that doesn’t mean they’re doing much lending along those lines. The CEO of regional bank Fifth Third, Tim Spence, said on the company’s 3Q call that the bank encounters private credit firms principally in leveraged lending, similar to what the Bloomberg article indicated; he noted with respect to press reports about private credit firms’ sizable “payment-in-kind” (PIK) lending (the Financial Times wrote about it here) that if “they’re willing to do those things and we’re not, by definition they’re going to scrape the most indebted companies out of the banking sector.”

For those unfamiliar, PIK loans allow borrowers the option of deferring their interest payments, but as Bloomberg explained, “the interest gets added onto the initial amount of money borrowed when it comes due and is compounded, meaning the underlying debt grows over its lifetime. While PIK can alleviate a short-term cash crunch, it can end up being far more expensive than normal debt.” The FT article cited Bank of America research showing that 9% of the income reported by private credit funds was in the form of PIK in the most recent quarter, and that 17% of the loans they hold give the borrower the option to pay at least a part of their interest with more debt. In 2Q, per the FT, 23.6% of the Blue Owl technology fund’s income was in the form of PIK, closely followed by Prospect Capital’s 18.6%, New Mountain Finance’s 17.7%, and Ares Management’s ARCC at 15.4%.

Who are some of the other prominent NDFIs to which banks are increasingly lending? Hedge funds, some of which operate with significant leverage. Along those lines, U.S. banking regulators have in recent months expressed growing concerns about banks’ increasing exposure to NDFIs. The Liberty Street Economics blog, which is analysis from New York Fed economists though which does not necessarily reflect the position of the New York Fed or the Federal Reserve, published three articles within a week in June analyzing the close relationship between banks and NDFIs. Around the same time, the Federal Reserve Board published a proposal seeking more specific data from bank holding companies and others regarding their exposures to NDFIs. According to the draft Federal Register notice, “U.S. bank exposures to NDFIs have grown rapidly over the past five years and reached about $2 trillion in the fourth quarter of 2022. This growth poses risks to banks, as certain NDFIs operate with very high leverage and are dependent on credit from the banking sector. Currently, data on exposures to NDFIs are limited on the FR Y-14, as banks report minimal information about these obligors, relative to other corporate borrowers. This lack of data hinders staff’s ability to consistently measure, monitor, and model the risks stemming from these exposures under stress.”

So why has banks’ loan growth been so heavily concentrated to NDFIs vs. households and businesses in recent years and year-to-date? Only the banks themselves can answer that question, but it stands to reason that NDFIs are more lucrative customers and growing more rapidly than others. With respect to the situation year-to-date, many of the country’s largest regional banks have reduced their full-year loan guidance in the last three months, similar to how many prominent consumer-related companies have been cutting their full-year sales guidance over the same period.

While GDP growth remains robust, owing at least in part to historically large federal government deficit spending, many other economic indicators have been far less so. Among them: (1) stagnant real (inflation-adjusted) average weekly earnings, (2) contractionary manufacturing surveys, (3) the Fed’s Beige Book survey of regional business contacts pointing to generally flat economic activity, and (4) persistent weakness in consumer companies’ sales performance. I don’t expect the latter to improve anytime soon with stagnant real earnings and a lack of loan growth to households and businesses, among other factors. As to the causes of that lack of loan growth, there are likely several: (1) deteriorating credit quality, (2) capital constraints among some banks, and (3) an unwillingness/inability to borrow among many households and businesses owing to the combination of high borrowing rates and uncertainty about what the future holds. The Fed can continue to cut the fed funds rate, but that doesn’t mean banks will be willing to lend more to households and businesses or that households and businesses will want to borrow more, even under the (at this point questionable) assumption that borrowing rates eventually fall in tandem with the Fed’s cuts.