Fred Furlong

English

Research Papers in Economics

FRBSF WEEKLY LETTER
May 24,1991
Financial Constraints and Bank Credit
Loan growth at commercial banks slowed
markedly in the second half of 1990 and
remained weak through the first part ofthis
year. To a large extent, the dropoff in lending is
explained by the responses of banks and their
customers to contracting output, rising unem-
ployment, and plummeting consumer and
business confidence.
A much more controversial explanation focuses
on the financial condition of commercial banks
and its impact on the availability of credit and on
the performance of the economy. The argument
is that poor loan quality, capital constraints, and
a stricter regulatOiy environment have reduced
the willingness of banks to lend. This has raised
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tions by banks is more than just a symptom of
a slack economy, and that it could impede the
recovery from the recent economic contraction.
This Letter examines how the financial condition
of banks has affected their lending. The Letter
also looks into how other credit intermediaries
have adjusted to offset the effects of slower bank
loan growth.
a reaction to the underlying health ofthe
economy.
A look at the relationship between loan growth
and loan quality for each of the twelve Federal
Reserve Districts is a useful starting point to
examine the effects of the financial condition
of banks on their lending. Chart 1 plots the
growth in total loans and leases at commercial
banks in 1990 against the overall quality of loans
for banks at the end of 1989. Loan quality is
measured as the ratio of performing loans to total
loans. The loan growth rates and the performing
loan ratios are weighted averages for each Dis-
trict. The chart suggests that bank loan growth
last year was positively related to the quality of
the loan portfolios. Other factors, hovvevei,also
affected loan growth in 1990. In the case of the
Boston District, the extreme weakness in bank
lending probably reflects the severity of the
overall economic problems in the New England
states, which had the country's largest percent
decline in employment last year. In the case of
the San Francisco District, on the other hand,
direct acquisition of thrift institutions by commer-
cial banks helped boost the overall loan figures
for banks in the West.
Tighter credit and economic conditions
Surveys on bank lending practices conducted
by the Federal Reserve and regularly reported
on by the financial press indicate that many
commercial banks tightened credit standards
from late 1989 through the beginning of this year.
According to these surveys, the tightening of
credit standards has been more prevalent for
businesses than for households.
Chart 1
Loan Quality vs. Loan Growth
By Federal Reserve District
San.
Francisco
Loan Growth
(9004/8904)
Percent
15
10
Banks give several reasons for adopting a
tougher stance on lending. The primary reasons
are a poor economic outlook and industry-
specific problems. These factors normally would
be expected to affect bank lending and so do not
suggest anything unusual. However, the other
reasons banks give for tighter credit standards
are related to banks' own financial condition,
namely, the volume of problem loans and capital
constraints. These considerations do suggest that
the restriction of loans by banks may not be just
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•
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A more formal test analyzes not only the growth
rates in loans at individual banks in 1990 and
the quality of loan portfolios, but also capital-to-
asset ratios at the end of 1989 and employment
growth rates in 1990 in each bank's region. The
analysis shows that all three factors-the capital-
to-asset ratio, the quality of a bank's loan port-
folio, and regional employment growth-had a
positive and significant effect on its lending. This
would appear to support the survey evidence that
the financial condition of banks and the condi-
tion of the economy affected their lending
decisions.
intermediaries, the combined net flow of funds
from life insurance companies, pension funds,
finance companies, and mutual funds jumped
by about $97 billion in 1990 compared with
1989. The decline in intermediation by deposi-
tories also was offset by the acquisition of failed
thrifts' assets by the Resolution Trust Corporation
(RTC)-acquisitions that were funded in large
part by Treasury debt. In effect, through the RTC
the federal government acts as a financial inter-
mediary, replacing federally insured deposits
at thrifts with federally guaranteed Treasury
securities.
Even with these changes in the channels of
intermediation, credit flows to certain sectors
of the economy were weak. Of particular note is
the commercial real estate and development in-
dustry. As Chart 3 illustrates, combined mortgage
flows to commercial and multifamily real estate
last year were low not only relative to recent
years, but also relative to the recession years of
the early 1980s. This contrasts sharply with what
has happened to net funds flowing to home mort-
gages. The difference may be due in part to the
increasing volume ofmortgage credit going
through federally sponsored mortgage pools last
year. These consist of pass-through securities col-
lateralized by home mortgages and guaranteed
by federally sponsored agencies. These second-
ary market instruments have helped to fiil some
of the gap in home mortgage financing left by
the contraction ofthrift industry. However, it is
likely that the paltry flow of funds to commercial
*Excluaes Treasury securities.
Chart 2
Net Credit Market Funds
4-Quarter Average
o
200
400
1985
$ Billions
Private 1
800
Nonfinancia! 600
.L.....L......L....I-L...L.....L......L....I .200
1990 1980 1975 1970
More nondepository intermediation
Some have argued that reduced bank lending
will prolong the recession and stall the recovery.
For example, if firms want to expand, they'll face
problems getting loans from banks to finance
their plans. This is a situation that would seem
to be made even worse by the contraction of the
thrift industry. Overall, financial assets (excluding
Treasury securities) at thrifts fell by almost $120
billion last year.
It's important to note that the financial condition
of a bank and the economic environment in
which it operates may not be factors that are easy
to isolate. For example, it is likely that regional
differences in economic growth and industry-
specific problems prior to 1990 affected both the
quality of a bank's loan portfolio and the bank's
views on the prospects for extending additiohal
credit Still, based on the evidence, we cannot
rule out that there was more to sluggish bank
loan growth last year than just a weak economy.
But the situation may not be all that bleak if we
consider not only bank and thrift lending, but
other means of financial intermediation as well.
Chart 2 shows that net intermediation (excluding
Treasury securities) by banks and thrifts com-
bined was nil in 1990. On the other hand, the
chart also shows that the decline in the net flow
of market funds to the private, nonfinancial sec-
tor was much less than the drop-off in bank and
thrift intermediation. In the chart, the net flow of
market funds includes the net issuance of cor-
porate equities and of credit market instruments.
The widening of the gap between the lines in
Chart 2 represents a shift to nevI channels of
intermediation that help offset the effects of
reduced bank lending. Among nondepositoryand multifamily real estate is due more to the
depressed condition of these sectors, as reflected
in the high vacancy rates in many parts of the
country, than to unusually restrictive supply
constraints,
Chart 3
Net Mortgage Flows
• Home EI Commercial
and Multifamily
$ Billions
, 300
250
200
150
increase in the reliance of these businesses on
nonmarket financing, and, thus, is not reflected
in the figures plotted in Chart 2.
These developments, along with the higher
profile of nondepository institutions, should have
helped to mute most of the adverse effects from
the'decline in bank and thrift intermediation on
the economy as a whole. For corporations, for
example, net funds raised in the market (the sum
of net debt and equity) in 1990 was not much
different from the level for 1989. In the case of
households, the drop in net market borrowing
last year was more or less in line with the slower
growth in personal disposable income and
movements in market interest rates.
1980 1982 1984 1986 1988 1990
Adjustments to leverage
In addition to a shift in the channels of inter-
mediation, nonfinancial corporations sharply
curtailed the retirement of equity last year, thus
reducing their demand for debt financing from
banks and other market sources, In 1990 the net
retirement of equity by nonfinancial corporations
totaled about $63 billion, roughly half the value
of net retirements in 1989, Even among noncor-
porate businesses, owners withdrew far less
equity in 1990 than in 1989, This represented an
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Conclusion
Survey results and other evidence suggest that
to a large extent sluggish bank loan growth
observed over the past several quarters reflects
a poor overall economic environment as well as
problems specific to particular industries. At the
same time, the financial conditions of commer-
cial banks also appears to have contributed to
tighter credit standards and to slower bank loan
growth. The negative effects ofthe slower com-
mercial bank growth along with those associated
with the contraction of the thrift industry, how-
ever, have been dampened by shifts in inter-
mediation patterns and other adjustments by
borrowers.
Fred Furlong
Research Officer
Opinions expressed·;n this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Judith Goff) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

Financial constraints and bank credit

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Financial constraints and bank credit

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