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"Regional banks in the US have sharply increased their corporate lending at the expense of underwriting standards and loan pricing, Moody's has warned." So writes Tracy Alloway in the Financial Times this morning.

Over the twelve months ending in September, Alloway writes, commercial and industrial loans (C&I loans) have risen by 7.4 percent, year-over-year, while all other bank loans only increased by 0.2 percent, year-over-year.

"Rating agencies and regulators have been saying that banks are making riskier corporate loans in an effort to boost their flatlining profits and fight off tough competition from other lenders and the bond market, where companies can also raise money."

What this is saying, to me, is that the loan demand at commercial banks for high-quality loans is quite low and so to make loans at all the commercial banks are having to stretch out into other areas and make concessions on credit worthiness and price in order to generate any kind of improvement in earnings.

There are two reasons why loan demand might be so low. First, the US economy is not growing very rapidly and so many high-quality companies are experiencing no need to borrow money.

Second, those companies that do need to borrow can find a lot of alternative sources of funds these days, beginning in the bond market which is showing historically low long-term interest rates.

On the supply side, there are the new regulations and the regulators. The Dodd-Frank reform act has made banking more costly and in many cases this has caused the borrowers that can go elsewhere…go elsewhere. This means that the commercial banks are left with a less desirable pool of corporate borrowers.

Note that Ms. Alloway is writing about regional banks. Regional banks have to rely on the revenues generated from making loans, more so than the giant banks that can earn additional revenues from trading sources and other fee generating products/services. If banks can't boost revenues through fee income then it has to go back to their fundamental business sources and do the best they can there.

If profits are suffering at these regional banks then they must be feeling pressed to extend themselves to make these loans.

It is not as if they did not have the funds. As of October 23, 2013, the commercial banking system had almost $2.4 trillion in excess reserves on deposit at Federal Reserve banks.

The question, up until now, has always been "why haven't the banks been lending out these reserves?" Concern has been expressed over the financial condition of the commercial banks or over the lack of business loan demand or the fear of regulatory disapproval.

It has been argued that one of the reasons that the Federal Reserve has been so aggressive in pushing reserves into banking is that Fed officials believe that if the banking system gets to the point that it has so many excess reserves around it will finally start lending again.

If the banking system starts to lend again, Fed officials believe that business investment will pick up and consumers will start to spend again and the economy will begin to expand more rapidly. And, unemployment will come down.

So, the Federal Reserve should be happy with the increases that are being posted in C&I loans.

The problem is that the quantitative easing of the Fed combined with the new regulatory environment has created so many distortions in the financial system that it is hard to really know what is going on.

For example, people have heralded the improvements in the housing industry. Yet, lending on residential real estate in the banking industry has not been increasing. Instead we hear that hedge funds and private equity and subsidiaries and asset management and private individuals are buying up properties to rent…and eventually re-sell. Funds for these purchases are showing up in commercial loans and not in real estate loans.

We see all types of alternative financial arrangements evolving outside of the commercial banking sector, in places like peer-to-peer lending and merchant funding and merchant banking and so on and so forth. Growth of lending in these areas is double digit.

We see that the bond market on a pace for a record year. Interest rates are low, but, longer-term interest rates are expected to rise…and, to rise by a significant amount. Thus, those that can raise funds from the capital market rather than the banking system…are issuing debt.

And, we see funding coming out in other ways in other sectors.

There is a glut of money sloshing around the financial system.

So, regional banks, in an effort to goose up profits are lending more and, apparently, the only way they can increase their loans and thereby increase revenues is to extend themselves by lowering credit standards and lowering relative loan rates for this quality of loans.

Moody's is not going to let them get away with this kind of behavior this time. Moody's and other rating agencies were soft in the earlier part of the 2000s. They do not want to get caught coming up easy now. Therefore, the warning is out.

This just puts the Federal Reserve in a more difficult position. If the quantitative easing of the Fed has resulted in commercial banks easing up on credit standards and underpricing their loans, behavior that Ms. Alloway writes "could come back to haunt them if company default rates were to rise," then what might happen if…and when…the Federal Reserve decides that it really must begin to taper its purchases of securities from current levels?

Sounds pretty messy doesn't it? Stay tuned!

Source: Moody's Says Banks Making Riskier Corporate Loans: Is The Fed Happy Now?