Since the financial crisis, the climate has been constantly changing for financial institutions. Bankruptcies allowed banks to grow in size as healthy banks absorbed failing banks. Since then new regulations have been imposed on the largest financial institutions changing (and in some cases eliminating) many of their most profitable operations. For example, the Volker Rule bans propriety trading by commercial banks. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and this is representative of increased regulation. For example, higher capital requirements mandates that a significant portion of a bank’s capital is tied up being unproductive rather than being put to use (i.e. put at risk in order to earn a return).
While some aspects of bank operations have been forced to shrink (or be eliminated), an area of growth for banks has been in their lending to businesses. According to the Wall Street Journal, “Lenders, too, are making bigger bets on an economic expansion at a time when tighter restrictions on many banking functions have placed more importance on core lending activities to boost earnings”. Although banks might have preferred to continue running certain risky operations such as proprietary trading, I think the increase in lending is is more beneficial for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is an vital source of credit that can promote booms in business cycles.
The increase in lending to business has been a two way street. According to the Wall Street Journal, “The rise is being driven both by banks, which are loosening their lending standards, and companies, which are seeking more money, bank executives said”. On the one hand, companies are seeking cash. If businesses use this cash to cover day-to-day expenses (i.e. meeting current obligations), then this might not mean so much for economic growth. If businesses use this cash for capital expenditures (i.e. long-term investments in equipment), then this might indicate a positive outlook for economic growth. On the other hand, part of the jump in lending is due to banks lowering their standards. Although increased availability of credit is important for economic growth, an over-leveraged can easily fall into a financial crisis. According to the Wall Street Journal, “And while relaxed standards aren’t likely to cause banks much trouble in the near future, it was reckless lending that helped fuel the financial crisis”. I agree that we are far from the dangerous lending that occurred prior to the financial crisis, however, I hope a minimum level of lending standards can be maintained so that we avoid another financial disaster.
Although banks have increased lending to businesses, the same cannot be said for lending to consumers. In order to reverse this trend, banks have loosened standards for home buyers. According to the Wall Street Journal, “Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market”. A meaningful re-acceleration of the housing market is crucial for justifying expectations for economic growth. Although we had a nice pop last year, the housing market slowed down in the fourth quarter and the first quarter of this year. Part of the slowdown might have been due to weather as well as the rising interest rates.
Rising interest rates making lending more appealing for a few reasons. According to the Wall Street Journal, “Some banks said the prospect of rising interest rates in the next few years could spur additional growth in commercial lending”. First, higher interest rates help creditors and hurt debtors. Although debtors must make higher interest payments, creditors get to collect higher interest payments. Second, many financial institutions have a mismatch between asset and liability maturity structures. Banks’ assets are mainly long-term loans and their liabilities are mainly short-term deposits. When interest rates rise, the value of the assets decrease more than the value of the liabilities because longer duration securities are more sensitive to changes in interest rates. Making more commercial loans enables banks to realign asset and liability maturity structures.