Recent Developments in Business Lending by Commercial Banks
Bassett, William F., Zakrajsek, Egon, Federal Reserve Bulletin
After growing rapidly during much of the 1990s, the inflation-adjusted value of commercial and industrial (C&I) loans at domestic commercial banks and at U.S. branches and agencies of foreign banks has fallen 19 percent since the beginning of 2001 (chart 1). (1) This striking decline in aggregate C&I loans masks important differences in lending patterns at domestically chartered institutions of different sizes and at U.S. branches and agencies of foreign banks. A drop in loans at large domestic commercial banks and at foreign institutions accounts for the entire contraction in C&I loans since January 2001. (2) In contrast, the real growth rate of business loans at small commercial banks, though it has declined appreciably, has averaged almost 4 percent annually since early 2001. The recent runoff in C&I loans contrasts sharply with that of the early 1990s: The earlier contraction in lending at large and small domestic banks was more uniform and was partly offset by a robust expansion of business loans at foreign institutions (chart 2).
Although branches and agencies of foreign banks are important participants in the C&I loan market, this article focuses on business lending at domestic institutions, for two reasons. (3) First, U.S. branches and agencies compete most directly with large domestic banks for customers in the C&I loan market. Therefore, the factors that depressed lending at large domestic banks over the past three years likely exerted a similar influence on foreign institutions. Second, the analysis of business lending at branches and agencies of foreign banks is complicated by the pronounced downward trend in their share of C&I loans (chart 3). The reduced intermediation by foreign institutions since the mid-1990s has been due largely to a sharp pullback in business lending by the U.S. branches and agencies of Japanese banks, many of which are saddled with a substantial volume of nonperforming loans and face significant pressures on their capital positions.
The divergence between large and small domestic commercial banks in the growth of business loans over the past three years appears to stem from the combined effects of weakness in demand for C&I loans from larger businesses and a relatively greater tightening of supply conditions at large banks. Although sharp cutbacks in capital spending and steep inventory runoffs since early 2001 have significantly reduced demand for C&I loans from borrowers of all sizes, the decline in loan demand from larger corporate borrowers--which maintain lending relationships mainly with large banks--has been especially pronounced. The reduction in demand for business loans from larger firms has been exacerbated by an evaporation of merger and acquisition (M&A) activity and a substitution of bond finance for bank loans on firms" balance sheets. On the supply side, large commercial banks tightened their credit standards and began imposing more stringent loan terms well before the recent economic downturn. These institutions further tightened their commercial credit policies as the economy slipped into recession and as a substantial deterioration in the credit quality of their borrowers pushed delinquencies and charge-offs on C&I loans to high levels.
The move toward a more stringent lending posture by domestic commercial banks before and during the recent economic downturn, although partly cyclical, has also been influenced by a reassessment of the risk-return tradeoff inherent in C&I lending, especially relative to the lax lending atmosphere of the mid-1990s. These structural changes in the way commercial banks price and allocate certain forms of business credit likely represent the cumulative effect of significant institutional developments in the C&I loan market since the late 1980s. In large part, these developments have arisen from the increased participation of nonbank financial institutions in the syndicated loan market, which in turn has contributed importantly to the growth of the secondary loan market and of leveraged lending--that is, lending to large below-investment-grade borrowers. …