Bank Loans Driving Business Credit Expansion

The bulk of business capital needs are being met by bank balance sheets, as opposed to shadow banking firms or capital markets investors. Is that a...
Vincent RyanJuly 18, 2012

After ceding a lot of corporate financing to shadow banking firms and capital-markets investors prior to the financial crisis, banks are driving corporate credit markets again, financing the bulk of credit expansion with their own balance sheets.

The total volume of bank loans of all types increased at a 3.3% annual rate in the second quarter, according to the Federal Reserve, in line with nominal gross domestic product growth, a continuing trend since the fourth quarter of 2011. And the third quarter is off to a good start, with lending activity at U.S. commercial banks expanding by $17 billion, or 13% annualized, in the week ended July 4.

In addition, commercial and industrial loans on U.S. banks’ balance sheets grew 12% in the second quarter after an 11% rise in the first quarter, according to Fed data, and dollar volume on banks’ books was at its highest level in two years. Bank credit growth is skewed toward business lending, according to a recent equity research report from analysts at investment bank Keefe, Bruyette & Woods. “Businesses have begun to increase leverage to take advantage of low interest rates,” the report points out.

This trend is mostly positive, but is having so much of capital creation dependent on banks’ balance sheets good for business borrowers or for the U.S. economy?

As banks are ascendant, capital markets are pulling back. Recent flow-of-funds data from the Federal Reserve show that the debt outstanding in the asset-backed securities market, for example, fell to $1.9 trillion from $2.2 trillion a year ago and $3.3 trillion in 2009. There is still no securitization market for most private-sector loans, say KBW analysts, who see “a continued decline in the ABS market for the foreseeable future.”

Meanwhile, U.S. corporate-securities issuance is down in a number of categories year-to-date, according to the Securities Industry and Financial Markets Assn.: convertible debt issuance is off 36% from 2011; leveraged loan issuance, 56%; common stock, 17%; and secondary equity offerings, 23%. Straight corporate-debt issues are flat with last year on a dollar basis, as are initial public offerings, whose numbers got a big boost by the Facebook deal in May.

Even venture-capital investments are down in 2012, according to the MoneyTree report from PricewaterhouseCoopers and the National Venture Capital Assn. VC funds invested $5.75 billion in 758 deals in the first quarter, a decline from $6.7 billion in 861 deals invested a year ago.

The problem with relying on banks for funding is that the markets are signaling that banks are not good credit risks.

U.S. and European banks’ credit default swap (CDS) spread averaged 19 basis points between 2004 and 2007, but since then the average has been 230 basis points, writes David Munves, a managing director at Moody’s Analytics, in a report published Tuesday. The average European and U.S. bank credit rating, as implied by CDS spreads, is “Ba1,” defined by Moody’s as a credit “judged to have speculative elements and subject to substantial credit risk.”

“Banks are a key part of the global economy, and higher and more volatile spreads limit their ability to attract capital and to fund themselves at reasonable levels,” says Munves.

Banks are also just generally riskier. “U.S. banks have higher risk profiles than before the financial crisis began, whether measured by credit spreads; equity prices; reputation, management and governance practices; or credit ratings,” he says.

And JP Morgan’s trading losses and the LIBOR scandal have once again raised questions about the risk controls at large banks. This is occurring at a time when banks are having a tough time growing earnings and hitting return on equity targets, despite the boom in commercial and industrial lending.

The quality of commercial banks as counterparties is worrisome but not bad enough to make companies avoid having them as creditors. There are plenty of positive trends at commercial banks. Due to regulatory changes, banks’ capitalization ratios are rising, and the quality of their loan portfolios is improving, with loan delinquency and net charge-off levels falling across the board.

Although they may be a greater credit risk in the capital markets, the largest commercial banks also have plenty of low-cost funding from deposits with which to finance loan growth. In its second-quarter earnings report last week, Wells Fargo said its core deposits were up 9% from a year ago, and its deposit costs were 19 basis points, down 9 basis points from a year earlier.

On the other hand, it would be costly for a large commercial bank to raise equity capital in the current market climate. The average U.S. bank has a market-price-to-book value of 66%, compared with 171% in 2007, according to Moody’s Analytics. On the debt side, if banks’ ratings worsen, the cost of credit could become prohibitive also.

After their experience during the financial crisis, companies know how precarious bank funding can be. Many banks pulled back on lines of credit and reduced unfunded commitments drastically when they encountered pressures financing their own businesses. That is not a problem right now, but if the U.S. economy worsens and capital markets don’t revive, banks might turn off the business-lending spigot once again. Companies should be careful not to rely too much on bank debt in their capital structure.

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