Tightening Credit Leads to Underperformance

Larry SwedroeNew research shows that the tightening of bank lending standards – as is the case now – has led to stock-market underperformance. But with banks playing a smaller role in corporate finance, that finding has lost some relevance.

In April 1990, the Senior Loan Officer Opinion Survey on Bank Lending Practices added the following survey item: “Net Percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Large and Middle-Market Firms, Percent, Quarterly, Not Seasonally Adjusted.” It is often called the “loan standards” question. A positive reading means that credit conditions are tightening for large and middle-market firms; a negative reading means credit conditions are lowering for those firms. Typically, the Senior Loan Officer Survey is released a month or two prior to the start of the next quarter.

A 2006 Federal Reserve Bank of Atlanta study found that credit-standard tightening shocks were associated with substantial declines in output and in the capacity of businesses and households to borrow from the banking sector, as well as a sharp widening of credit spreads. The result was that GDP growth declined significantly within two quarters. For example, there was a sharp and sudden reduction in the availability of credit at the time of the Long-Term Capital Management (LTCM) crisis in the early autumn of 1998. A similar pullback in the supply of bank loans occurred immediately before the economic downturn in 2001 and before and during the early phases of the great recession.

The 2012 study, “Changes in Bank Lending Standards and the Macroeconomy,” found that “an adverse loan supply shock of one standard deviation is associated with a decline in the level of real GDP of about 0.75 percent two years after the shock, while the capacity of businesses and households to borrow from the banking sector falls almost 4 percent over the same period. This shock also leads to a substantial rise in private credit spreads.” Eventually, the economic effects of the deterioration in the supply of credit elicit a significant easing of monetary policy.