Concentrated Bank Lending Worrisome

Bank lending activity has a crucial impact on both the interest-rate complex and the economy at large.

In particular, an increase in bank lending could accelerate U.S. growth and/or inflation, which would certainly have an effect on rates. There is certainly some evidence that bank lending is accelerating here, but the situation is complicated.

I've got four charts to illustrate my point.

First, we have bank assets by type.

Here I've normalized to the level that existed at year-end 2007. Notice two things. Residential real-estate lending (which is standard mortgages plus home equity loans) has been falling for about a year and is now around where it was in 2007.

This reflects a drastic drop in home equity loans and very modest growth in first-lien mortgages, the bulk of which banks have been eager to sell to investors. Commercial real estate (CRE) dropped substantially during the crisis, but has been rising steadily for about a year. Most interesting is the commercial and industrial loan category (which is your classic business loans). Over the last three months this has really accelerated. Overall, this gives us the all-loan category showing an acceleration to the upside.

How does the current pace of loan growth compare to past periods?

Here we see the acceleration in C&I loans more clearly. Indeed, the pace of C&I lending is approaching the pace of real estate lending during the bubble period. Finally, we see that the pace of securities buying has dropped substantially. Banks appear to favor lending over buying government bonds for the first time since the crisis.

Despite the substantial increase in total lending over the last year, banks have plenty of dry powder to lend a lot more. If we look at loan growth as a percentage of deposits, a crude measure of capacity to lend, we see that no category is growing much.

Indeed, if we look at the next chart ...

Total lending as a percentage of deposits is far lower than pre-crisis levels and still seems to be trending lower. This tells us that despite the fact that lending is growing, deposits are growing even faster.

I look at the bank lending picture with considerable concern. Problems arise when banks start concentrating their lending in a relatively small category of loans. In the process, they run out of really good borrowers and start to lend to marginal borrowers. That eventually leads to an uptick in default rates. Today, banks are clearly concentrating on floating-rate C&I loans. Not coincidentally, securitized bank loans has also been an extremely popular investment category with mutual fund flows into bank loan funds enjoying nearly two-straight years of consecutive weekly inflows. Not only that, banks appear to have plenty of capacity to expand lending further. If this new lending is overly concentrated in subsets of loan types, this could certainly result in an imbalance.

But before we get there, I suspect we'll first see an increase in bank lending resulting in higher short-term interest rates. The Fed will be watching bank lending carefully as a forward indicator of inflation risk.