The landscape in which financial institutions operate is very different now than it was before the financial crisis of 2008. Mergers and acquisitions between healthy firms and failing firms allowed the strong to get stronger and subsequently gain market share. As the market has grown more concentrated, it has also grown less competitive. Although competition is a corner stone of capitalism, maybe large banks help promote financial stability. Whether or not this is true, new government regulations have been enacted with the sole purpose of reducing risk taking by financial institutions.
Unable to put as much capital at risk as before, banks are shedding operations that were once major profit centers. For example, the Volker Rule bans propriety trading and limits commercial banks to hedging and market making. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and I believe this is representative of increased regulation. Higher capital requirements mandates that a significant portion of cash is set aside. Essentially, cash must be tied up as an unproductive asset (rather than being 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 commercial lending (i.e. 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 riskier operations in order to earn a higher return, more lending to businesses is certainly better for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is a vital source of credit that promotes booming 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 businesses might be indicating a positive outlook for economic growth. On the other hand, banks very much want to lend the cash as evidenced by lower lending 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”. As long as commercial lending is monitored correctly, then the risk should be manageable.
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 homebuyers. 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 the housing market seemed to heat up last year, it slowed down in the fourth quarter and the first quarter of this year. Although one factor contributing to the slowdown might have been the winter weather, rising interest rates also certainly played a role. Higher interest rates decrease affordability for homebuyers.
Changes in interest rates have significant implications for both borrowers and lenders. 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”. Rising interest rates make lending more appealing for a few reasons. First, creditors get to collect higher interest payments. At the expense of debtors, banks earn increased revenue from lending activities. 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. Banks can hedge interest rate risk and realign asset and liability maturity structures through commercial lending.
I cannot help but be concerned when I hear banks are lowering their lending standards because I am reminded of bank conduct during the housing bubble. I can only hope that regulators are watching more closely this time.