Bank Lending Still Booming

by: Calafia Beach Pundit

Outstanding loans at U.S. banks have increased over $800 billion in the past 12 months, and have been increasing at about a 7.5% annualized rate over the past year and two years. One area of bank lending - Commercial & Industrial Loans - has been expanding at 10.5% annualized pace for the past 5 years, and has expanded by over $200 billion in the past year, up 11.6%. Banks still have over $2.5 trillion of excess reserves (reserves in excess of what is required to collateralize their deposits), so bank lending could theoretically continue to expand at heady rates almost indefinitely.

As the chart above shows, the pickup in bank lending got started about two years ago, after being very weak from 2008 through 2013. It may just be a coincidence, but bank lending started picking up right around the time-in early January 2014-the Fed announced that it would "taper" its purchases of notes and bonds, which turned out to be a prelude to the end of the third round of Quantitative Easing. Prior to that time, banks had apparently been eager to accumulate excess reserves, and relatively unwilling to lend to the private sector. In effect, by accumulating excess reserves, banks were lending principally to the Fed. In the past two years this has shifted, with banks lending much less to the Fed and much more to the private sector.

C&I Loans (shown in the above chart) are a good proxy for bank lending to small and medium-sized companies-those that are too small to access the capital markets directly by selling bonds. They've been on a tear ever since the end of 2010. I've interpreted this to mean that banks as well as businesses have become more confident in the future: banks are more willing to lend, businesses are more willing to borrow. Lending isn't always good for economic growth, but in this case I think it has helped boost growth, because it is the result of increased confidence. The big international corporations may be borrowing to fund dividends and buybacks (and avoid double and triple taxation on their foreign profits), but I doubt that is the case with much smaller companies.

There is no sign here of any deterioration. Lending activity remains robust, and that suggests that the underlying economic fundamentals of the economy have not deteriorated and are possibly even improving. This lends support to the Fed's decision to start normalizing interest rates.

Since increased lending is a reflection of a reduced demand for money (borrowing money is like shorting a stock: you benefit if the value of the stock declines), it is entirely appropriate for the Fed to adopt a policy that attempts to offset that decline in the demand for money. Raising the interest it pays on excess reserves makes banks more willing, on the margin, to hold those excess reserves and less willing to increase their lending to the private sector. However, increasing IOER to 0.5% is unlikely to make a big difference, so we should expect to see further rate hikes going forward.

The risk the Fed runs is raising rates too little, too late. That's what has happened in nearly every business cycle expansion, and it explains why inflation almost always rises until the point when the Fed has finally "caught up" and tightened by enough to severely constrain the supply of credit-at which point the economy slips into recession. We are still years away from another of these credit roller-coaster rides, but that doesn't mean we don't need to worry.

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