That’s it. The only chart you need to worry about right now if you’re trying to figure out where the economy is heading. Construction and industrial (C&I) lending is a $2.8 trillion business (approximately) for banks nationwide. If they roll over, we have a soft landing. If they roll hard, we have a hard landing. It’s not complicated, the only thing that remains unresolved is the timing and severity.
C&I loans take the form of a lump sum or revolving credit. They usually last a year or two and are for businesses so they can expand, hire, invest in new equipment or facilities, improve owner-occupied real estate, or simply have working capital. That’s what small and medium banks really do outside of mortgages and checking accounts. It’s their real job. It is their whole purpose to exist. Small businesses cannot tap Wall Street for capital. They cannot issue bonds or sell shares. They need banks to develop, improve and finance new projects.
The economy also needs this activity. Over the two decades between 2000 and 2019, the SBA estimates that 64.9% of all new jobs were created by companies with fewer than 500 employees. This represents two-thirds of total job growth in the United States over the past two decades, primarily funded by C&I loans and credit agreements between banks and business owners.
When banks begin to divert capital from this line of business or say no to new lending, strains begin to appear throughout the economy. The confidence of small business owners takes a hit. Employment is hitting the wall. This is how recessions materialize from being something the stock market is worked on to becoming a real, tangible reality on Main Street.
So here’s a look at the net percentage of banks reducing C&I lending by tightening their lending standards, via Bank of America this morning:
You can see that historically, the lending standards of the big banks rise and fall with those of the smaller banks, so if we see the lending contraction continue in the smaller banks, the impact will be significant for everyone. We know that the big banks are currently the beneficiaries of the regional bank panic in terms of transferring deposits, but that does not mean that they are going to prey on loan growth. Everyone is on defense right now. This is the very definition of a financial shock.
The FOMC’s decision to raise interest rates last week will look much more ridiculous as the weeks and months pass. BofA economists note the following usually follows a shock like the one our banks are currently experiencing:
We estimate the effects on economic activity of changes in bank lending standards and conditions using vector autoregression (VAR) on quarterly data from 1991 to 2022 (see the report Estimating downside risk from a sharp tightening in bank lending standards, March 21, 2023). We find that a one standard deviation shock to C&I lending standards and banks’ willingness to lend to consumers results in a 1-2% cumulative decline in personal consumption over six quarters, a cumulative decline of 2-4% employment over six quarters, a 10-15% cumulative decline in investment in structures and equipment over six-10 quarters, and a 15% decline in real C&I loan growth over 10 quarters.
Stricter standards on consumer loans reduce consumer loans by 10% cumulatively over ten quarters. We also see fairly short lags between any tightening of lending standards and economic outcomes; the effects tend to show up in about two to three trimesters. In addition, shocks to lending standards for C&I and consumer lending are very persistent and generally do not fade. This is similar to findings from previous research, where we found that shocks to financial conditions can lead to prolonged declines in activity data…
SVB, Signature, Credit Suisse are not small banks. Their collective demise this month, regardless of what happens with depositors, will be something we’ll consider the start of the hard landing. I don’t know if the Federal Reserve’s rate cut in the second half of the year would even matter at this point. Maybe too late.
Central banks continue to follow the playbook and so do we
Bank of America – March 24, 2023