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Economics Weekly

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Credit conditions have eased, but challenges remain

Mon, Oct 26 2009, 11:01 GMT
by Lloyds TSB Financial Markets Economic Research Team

Lloyds TSB Financial Markets

The Bank of England’s (BoE) latest monthly Trends in Lending report was published last week. The report provides a timely assessment of lending conditions in the UK, and provides an update on the BoE’s recently released Q3 Credit Conditions survey. Below, we examine the recent BoE surveys and assess the extent to which credit constraints have eased. With the UK FTSE-100 recently hitting a new twelve-month high and spreads in the interbank markets having dropped to their precrisis levels, sentiment in the financial markets have clearly improved. But a prerequisite for any enduring financial or economic recovery is a sustained rise in the supply of and demand for credit.

Decline in credit growth has been led by the corporate sector
Chart a shows recent trends in lending to the non-financial corporate (PNFC) and household sectors. Since the onset of the credit crisis in summer 2007, lending growth across both sectors has slowed sharply. The slowdown has been particularly sharp in the PNFC sector where, in the twelve months to August, lending fell 4.2% - its sharpest drop since 1994. Notably, in the household sector, annual lending growth for both secured and unsecured credit has slowed, but remains positive. Within the household sector, however, divergent trends are emerging. In keeping with the recent signs of improvement in the housing market, loans for house purchase appear to have bottomed out. The annual rate of growth of secured lending rose from 0.8% in July to 0.9% in August – the first monthly increase since September 2007. By contrast, the slowdown in unsecured lending growth appears to be accelerating. Indeed in August, net consumer credit posted its second consecutive monthly decline for the first time since the series began in the early 1990s (see chart b).

But the BoE surveys report that credit conditions have improved
As the BoE has acknowledged, it is difficult to disentangle the extent to which the drop in lending growth has been driven by a weakening of supply or a weakening of demand. There can be little doubt that both have played a role. The pressure on banks’ balance sheets and the rise in the cost of wholesale and retail funding have clearly impacted on the willingness of banks to extend credit over the past two years. At the same time, the fall in house prices, the onset of recession and, for some companies, the availability of cheaper sources of finance have weakened the private sector’s demand for MFI loans.

Nevertheless, the BoE’s recent credit surveys suggest that conditions have improved. Chart c shows the net percentage of lenders reporting a loosening in credit availability. The biggest improvement has been in the availability of loan finance to PNFCs. Since September 2008, the net balance of lenders reporting a loosening in credit availability to the corporate sector has risen from -36% to +25% (a swing of 61%). The percentage balances for both household loans for house purchase and unsecured credit have also risen, but remain in negative territory. Admittedly, the improvement in the availability of loan finance in all three areas has been from a low base, and other surveys continue to report that credit conditions remain tight. Nevertheless, policy initiatives such as quantitative easing, coupled with improvements in liquidity in the wholesale funding markets have clearly began to have a positive impact on the availability of loan finance.

Demand for loans has also risen
Chart d shows that there has also been a rise in the demand for MFI credit from both corporates and households. The biggest improvement has been in loans for house purchase, where the net balance of lenders reporting an increase in demand has risen from -69% to +48% over the past year. By contrast, demand for unsecured bank finance has improved only marginally. The ongoing weakness in the demand for unsecured credit is consistent with the downturn in consumer spending and the ongoing desire of households to rebuild their precautionary savings and strengthen their balance sheets.

Amongst PNFCs, the rise in loan demand appears to have been driven by small and medium-sized companies. This is largely explained by the fact that larger companies have sought to substitute away from bank finance towards alternative sources of funding. This is consistent with the rise in capital market issuance this year and the net repayment of corporate bank loans. In the three months to August, PNFCs repaid a net £20bn. The repayment appears to have been financed, at least in part, by a rise in equity and bond issuance (see chart e). Smaller companies, by contrast, remain highly reliant on bank finance. Indeed, lending to SMEs with a turnover of less than £25mn per year has risen by 1.6% over the past twelve months, while lending to those with a turnover of less than £1mn, has risen by an annual 6.4%.

Credit conditions set to ease further, but significant challenges remain
Looking ahead, the BoE’s latest credit conditions survey suggests that lenders expect demand for loans from both large and medium-sized companies to increase in the fourth quarter. The anticipated rise reflects expectations of stronger M&A activity, increased corporate confidence, and a rise in demand for working capital, particularly from those companies that may have de-stocked too rapidly and now need to rebuild their inventory levels. The survey suggests, however, that credit conditions facing the household sector are likely to be mixed in the months ahead. While the availability of secured finance is expected to rise further, demand for mortgages for house purchase is anticipated to drop, although this may partly be due to the usual seasonal lull in housing activity in Q4.

By contrast, the anticipated weakness in unsecured lending is likely to be more enduring. As the ongoing rise in unemployment, the recent weakness in retail sales and the surprise 0.4% quarterly drop in GDP in Q3 highlight, the UK economy, and the consumer sector in particular, continue to face substantial headwinds. Faced with these headwinds, the desire of both households and corporates to deleverage their balance sheets is likely to remain a sizeable impediment to a rapid economic recovery not only in Q4 but over the year ahead.

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Published on  Mon, Oct 26 2009, 11:11 GMT