Short-term Credit: Cycles and Trends – Part I

Pro-cyclical Credit—Bank/Nonbank Finance

As each economic cycle matures, the problem of pro-cyclical credit appears as both the demand and supply of credit rises with the economic expansion. One example is the tendency for growth in short-term credit, such as call money, to rise with the cycle—independent of the growth of the underlying money supply—an expansion of financial transactions relative to the underlying monetary base or supply. This call-money expansion and rising short-term rates have a long history going back to France in the 1880s and the U.S. in the 1920s. In the current economic expansion, we have witnessed an expansion of credit from non-banking sources independent of the growth of bank lending and the money supply (top graph). Popular commentary focuses on the slow pace of bank lending but fails to notice the gains in nonbank finance.

As long as growth continues and financial markets rise, all this appears normal. The problem, as history illustrates, is that any slowdown in economic growth or financial gains leads to calls on all this credit and even higher risk-adjusted interest rates.

Pro-cyclical Credit Growth—Both Up and Down

As illustrated in the middle graph, commercial and industrial lending has a strong pro-cyclical element in its behavior. On the demand side, firms are likely to retrench at times of recession (shaded areas) and economic weakness/uncertainty (1985, 1998) for example. Without a clear, positive, vision of the strength of the economy, firms will remain cautious on going to the borrowing window. Meanwhile, on the supply side, banks will be cautious to lend in a recession period and periods of economic uncertainty. Moreover, the depth of the decline during the 2008/2009 period reflects the influence of the extent for financial regulation.

To emphasize the structural shift in ban/non-bank lending, note how bank lending has slowed in recent years despite the strength of the overall economy.

Loan/Deposit Ratio: A More Cautious Bank Lending Environment

Both cyclical and secular characteristics appear in the behavior of the loandeposit ratio at commercial banks (bottom graph). Over the 1980s and 1990s cycles, loans expanded relative to deposits as banks employed a more intensive application of their funds to lending in an expanding economy. When recession hits, we witness a retrenchment in bank lending.

On the secular path, up until the current cycle, the intensive use of loans relative to deposits rose in the prior three cycles. Then, it stopped. During the current cycle, there is no cyclical uptrend. Bank lending has become more cautious, and this helps explain the recent modest economic growth.

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