Banks to Borrowers: Tighter, Tighter

January 17, 2023 | Evan Frazier, CFA, CAIA, Senior Research Analyst

Two-line chart showing U.S. banks tightening lending standards over several periods. Chart subtitle:  A significant portion of domestic banks have tightened lending standards given the uncertain economic outlook. Chart visual description: Data is quarterly and through 4Q22. Y-axis is labeled “Net Percentage of Domestic Banks Tightening Standards,” and ranges from -40% to +100%. X-axis is labeled with quarters in 10-quarter increments, beginning in 2Q90, then 4Q92, 2Q95, and so on through 4Q22. Two data series are charted with lines, and recessionary periods are shaded with light blue behind them. First data series is named, “Commercial/Industrial Loans to Large and Middle-Market Firms” and is charted with dark green line. Second series, “Commercial/Industrial Loans to Small Firms,” is charted in bright green. Chart data description: Leading up to recessionary periods, (four plotted; 3Q90-2Q91, 2Q01-4Q01, 1Q08-3Q09, and 1Q-2Q20) more banks tightened lending standards, with the peak typically near the middle of the recession. Generally, in between, fewer tightened to the point of negative data (or decreasing standards) until the next ramp-up to recession. Peak for Large/Middle line was in 4Q08 with 83.6%; peak for Small line was same quarter at 74.5%. The 4Q22 point was at 39.1% and 31.8%, respectively. Chart source: Source: Federal Reserve Bank of St. Louis as of December 31, 2022. Large and middle-market firms are those with annual sales of $50 million or more, and small firms are those with annual sales of less than $50 million. End chart description. See disclosures at end of document.

If recent data points collected by the Federal Reserve are any indication, major financial institutions are bracing for a period of challenged economic activity. The latest edition of the Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices, which surveyed roughly 70 domestic banks and 20 U.S. branches and agencies of foreign banks, found that nearly 40% of these organizations have raised standards for commercial and industrial (C&I) loans to large and middle-market firms over the last several months. According to the survey, these tighter conditions were most widely reported for costs of credit lines, premiums charged on risky loans, covenants, collateralization requirements, and spreads of loan rates over the cost of funds. It is important to note that these tighter conditions are not limited to C&I borrowers, as standards for commercial real estate and credit card loans, as well as home equity lines of credit, are back to levels last seen during the early days of COVID-19. Respondents cited reductions in risk tolerance, decreased secondary market liquidity for commercial and industrial loans, lower competition among lenders, and a less favorable economic outlook as the primary reasons for these higher lending standards.

In a special section of the most recent SLOOS, banks were asked to assess the probability and potential severity of a near-term economic downturn. Roughly 80% of respondents believe there is at least a 40% chance of a U.S. recession in the next 12 months. On a more positive note, none of the banks included in the survey believed the downturn would be severe, with roughly 75% of respondents indicating the recession would likely be moderate and 25% expecting it to be mild. For context, severe recessions have historically resulted in a 3.4% reduction in real GDP and an increase of 3.6% in the unemployment rate, according to Federal Reserve data. Mild and moderate recessions, on the other hand, have seen real GDP decline 0.6–1.1% and increases of 1.1–1.8% in the unemployment rate.

Whether or not these predictions ultimately come to fruition, Marquette recommends remaining invested throughout the economic cycle, as downturns can be notoriously difficult to time. Securities markets also tend to be forward-looking, so much of the pain associated with a possible future recession may already be reflected in the current landscape. As banks and other market participants continue to assess economic conditions, and as markets react, and overreact, to those changing expectations, it is important for investors to maintain diversification across asset classes and remain focused on long-term objectives.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Evan Frazier, CFA, CAIA
Senior Research Analyst

Get to Know Evan

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

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