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Speaking of the Economy
Money locked up in chains
Speaking of the Economy
Sept. 27, 2023

Where is the Credit Crunch?

Audiences: Economists, Business Leaders, Bankers, Community Investors, General Public

Sonya Waddell and Chen Yeh provide an update on credit market conditions, based on recent results of the CFO Survey and other surveys of borrowers and lenders. They also discuss the macroeconomic forces that shape the supply and demand sides of the market, including the current round of monetary policy tightening. Waddell is a vice president and economist and Yeh is an economist at the Federal Reserve Bank of Richmond.


Tim Sablik: Hello, I'm Tim Sablik, a senior economics writer at the Richmond Fed. I'm joined today by Sonya Waddell, vice president and economist at the Richmond Fed, and Chen Yeh, also an economist at the Richmond Fed. Sonya and Chen, welcome back to the show.

Sonya Waddell: It's good to be here, Tim.

Chen Yeh: Glad to be back, Tim.

Sablik: I'm glad to have you both on here to talk with us about what is happening in the world of business credit. Firms of all sizes use loans to finance improvements, expansions, and other investments. But if loans become more expensive or are harder to obtain, we might expect that to have some impact on business activity.

As the Fed has been raising interest rates, credit has become more expensive across the economy. We also witnessed some trouble in the banking sector this spring, which may have prompted banks to scale back on their lending activity.

Sonya, let's start with you. What are firms reporting about their access to credit?

Waddell: From what I'm seeing and hearing, it's a tightened credit environment stemming from rising rates and uncertainty in some sectors — for example, some segments of commercial real estate — that's dampening supply of and demand for credit. Neither our surveys nor our anecdotes indicate that firms or financial institutions are ascribing any challenges with credit to the troubles in the banking sector from the spring.

Let me talk a little bit about what we have heard from firms in our Fifth Federal Reserve District business surveys and the CFO Survey in the last few months.

Back in May, we asked firms in the Fifth District — so this is the South Atlantic spanning from Maryland down through South Carolina — if they'd applied for new credit and, if they did, was it more difficult to obtain. About 60 percent of firms that applied for new credit reported that obtaining credit was either somewhat or much more difficult than it was earlier in the year. The rest reported no change.

Why was it more difficult? Well, according to firms, lending standards were simply more stringent. Of course, more than three-quarters of firms in this survey did not apply for new credit at all.

In addition to our own regional surveys, we collaborate on the CFO Survey with the Federal Reserve Bank of Atlanta and Duke's Fuqua School of Business. In a June iteration of that survey, we asked firms if access to or the cost of financing constrained their investment or spending plans. Most firms reported that, for the first half of 2023, access to or cost of financing had not constrained their plans, although small firms were more likely to report constraints than large firms. Altogether, about 30 percent of small firms reported that their plans were constrained in the last six months. About 40 percent expected that access to or the cost of financing would constrain their investment spending plans between June and the end of the year.

These results are all from the perspective of firms. We can also look at this question from the perspective of lenders and, for that, one source of information is the Senior Loan Officer Opinion Survey, or colloquially called the SLOOS, that is collected quarterly by the Federal Reserve Board. Respondents to the July 2023 iteration of that survey indicated that, on balance, lending standards were tighter for both commercial and industrial, and commercial real estate loans.

Sablik: Yes, thanks very much for that overview.

One interesting thing that jumped out to me from the Fifth District survey results is that less than 25 percent of firms said that they sought credit. Do you have any sense of why most businesses are not seeking loans? Have higher interest rates made loans too expensive or are banks not lending as much? Or, is there just not a lot of demand for credit right now?

Waddell: The loan officer survey did indicate that banks are hesitant to lend. Lending officers also reported that demand is lower. Some of this might be the tighter credit conditions that they mentioned.

From the business surveys that we look at, a lot of firms simply don't finance spending via borrowing. However, rates are likely making a difference. In that May survey that I mentioned earlier, 20 percent of firms that didn't borrow reported that interest rates were too high. We heard this anecdotally as well. In some spaces — commercial real estate being chief among them — the increase in rates makes it difficult to make deals work.

This morning, we released the third quarter 2023 CFO Survey, where we asked firms the extent to which the current level of interest rates was causing them to pull back on capital spending plans. About 40 percent said that it was, which is notably more than the 30 percent who said that they were pulling back on capital spending plans due to higher interest rates when we asked the same question in the fourth quarter of 2022. The spending plans of small firms seemed particularly impacted.

Of those who said that the current level of interest rates was not causing a pullback, more than half said that they simply do not borrow to finance capital spending. Even more firms said that they do not borrow to finance non-capital spending. These results again corroborate the idea that many firms simply do not finance spending with borrowing.

But there's something else, too. Firms will not demand credit if they can't use it to make a profit. In spite of the unexpectedly strong economic growth in the last few years, uncertainty and concerns about future demand prevail. This came out of the most recent CFO Survey, where a fair share of firms reported that there were other factors causing the firm to pull back on capital or non-capital spending, particularly economic uncertainty and weaker demand by customers.

Just one more thing. More than 17 percent of firms in the third quarter CFO Survey reported they were pulling back on spending because of difficulty hiring employees. We hear this in other places, too.

Sablik: Digging a little bit more into this idea of how firms finance their spending, Chen, can the economics literature shed any more light on this question [of] what the typical sources for financing are for firms?

Yeh: I would say the whole field of finance is about what is the optimal financial structure for firms. It's hard to summarize a whole field in one answer, but let me try to give you an overview.

You can think about financing through debt. For example, you go to a bank, you take out a loan and then, after a certain period, you pay interest as a firm. The second group is equity financing, which is basically getting the resources, in turn, for people to have a say in your firm. For example, you issue shares. The third group is retained earnings, so think about it as saving by firms.

There's a recent study by Frank and Goyal that gives a good overview of what type of firms choose what type of financing. Private firms mostly use retained earnings and bank debt, whereas small public firms use equity financing and the larger public firms primarily use retained earnings and corporate bonds.

Macroeconomics tends to focus on bank debt in particular. There we see two types of bank debt. One is what we roughly call collateral constrained — the amount you can borrow as a firm depends on what we call the liquidation value of physical assets. If a bank provides you with some funds, they take on a risk — you could default. In that scenario, the bank would like to have safety. They want some collateral. Usually, the assets that you put down are physical assets, so think of an expensive machine.

So that's one [type of bank debt]. The second is what we call earnings-based constrained or cash-flow-based lending. Some firms might not be able to put down physical assets, but they can show they have generated a lot of revenue in the past or in the future, or they are able to generate a lot of profits. So, the bank will be able to take those profits if needed if the firm defaults.

What's kind of interesting is that a big chunk of the macroeconomics literature has focused on collateral constraint. But there's this recent paper by Lian and Ma that indicates that 80 percent of the value in debt by public firms is actually based on cash flow.

Sablik: Interesting.

Do we have any sense if the fact that few firms are seeking credit right now, is that unusual based on historical experience?

Yeh: It's difficult to say whether the recent drop in commercial and industrial loans — C&I, in short — is really due to a gap in demand. As Sonya was saying before, lending standards have tightened, so we should also consider supply factors.

When you look at the aggregate data in commercial and industrial loans, we've seen that has grown about 0.6 percent on an annual basis. When you adjust for inflation, this number becomes 0.9 percent. When you look at this trend and what we call deviations from trend, what we see now based on the past few months, it's not really unusual. Yes, it's about one and a half or 2 percent below this trend, but that doesn't seem particularly unusual compared to other historical episodes.

What we do see from the SLOOS, where you can go more into detail in the micro data, is that the net percent of banks that report there's a stronger demand for these commercial and industrial loans is actually at one of its lowest levels since the survey began, which is 1991. In particular, banks report that the demand for commercial real estate loans is at a historical low level.

Sablik: One of the ways that monetary policy tightening works is through tightening credit conditions. As you both have been discussing, there's certainly evidence of that in the current cycle. But I'm wondering: if few firms are seeking loans, does that also potentially limit the effectiveness of Fed policy?

Waddell: This is a tough question to answer, Tim. From the May Fifth District survey, the firms that did apply for new credit did so primarily to expand their business, pursue new opportunities, or acquire business assets. To the extent that firms don't expand where they would have before, that should curb economic activity, which is the purpose of the tighter monetary policy.

Although we've seen relatively strong GDP growth in 2023 — admittedly stronger than most would have predicted — we are seeing some slowing in employment growth and some easing in the ability to find workers, although as I mentioned earlier it's still not necessarily easy.

Here's something important out of the most recent CFO Survey. In total, about 60 percent of respondent firms said that they either were pulling back due to the current level of rates, they would pull back if rates stayed where they are for another 12 months, or there was some rate at which they would pull back. It seems unlikely, at least to me, then that tightened monetary policy will not have some effect on spending, investment, and real economic activity over the course of the next 12 months.

Yeh: When interest rates go up, borrowing becomes less attractive and firms are less willing to borrow. So, you could argue that the interest rate policy of the Fed is less effective if many firms are not interested in borrowing in the first place. If their incentives to borrow are orthogonal to interest rates, then you could say it's less effective. But, as Sonya was saying, it seems that demand for loans is low exactly because of these high interest rates. It's a bit unclear, but I would say there is some effect because firms are responding to higher interest rates.

Sablik: Listeners may have also heard the famous adage that monetary policy operates with long and variable lags. Could it be that we're still too early in the tightening cycle to see the full effects on business credit, or is this time different?

Waddell: I love that it's a famous adage, Tim, just like the SLOOS is a colloquialism.

Sablik: It's famous to us.

Waddell: This is a really, really important question. I think to some extent, it depends on your lens.

Monetary policy operates with lags and there's still a fair amount of uncertainty about the duration of the lags with which monetary policy tightening affects economic activity and inflation. I've heard estimates that it can take anywhere from nine months to two years for monetary policy to materially affect inflation or real economic activity. Paul Ho, one of our economists, wrote a really informative Economic Brief on this topic that came out in May.

Another recent publication, this time from some economists at the Board of Governors, creates a financial conditions index to assess the extent to which financial conditions create headwinds or tailwinds in economic activity. Their results indicate that financial conditions are likely to be a drag on GDP growth in the next year.

It's also worth noting that many of the factors that affect firm borrowing — asset prices or prime lending rates, for example — respond quickly to not just changes in the target Fed funds rate, but also to expectations about monetary policy. So, although it might be too early to have seen the full effect of Fed tightening on economic activity, I think we're already seeing that filter through to business credit as evidenced by our survey results.

As I said, though, expectations matter, too. We've heard varying things from contacts about how expectations are driving their decisions. Some say they're seeking financing for capital projects now in case rates go up further. Some say they're waiting to see what the Fed does next, or that they expect a ton of capital to flood the market when rates do start to fall. Still others talk about riding the yield curve or seeking longer term financing for, say, a commercial real estate project in order to cut some points off of their current rate, even though that might cost them in a few years. We've been in a really low rate environment for a long time, so firms are still figuring out exactly how to adjust.

Yeh: I agree with Sonya on all these points. One particular point is that it could take months before we see the peak, let alone the full effects, of monetary policy.

What I do think is that, as Sonya was evidencing from the Fifth District survey results, we are already seeing some effects. There are no strong signs that these lags that you were mentioning, Tim — the lag of monetary policy — are particularly long at this moment.

We could argue, and it's maybe a bit cynical, that inflation has been quite high for quite a long time despite the Fed raising interest rates. But we also should note that we live in quite special times, all these effects like the pandemic — think about supply chain disruptions — surging demand due to relief funds. It's hard to say whether the lag of monetary policy has been longer than usual.

Sablik: What are some things that you'll both be watching in the coming months?

Waddell: Other than broad indicators of economic activity, I'll be looking for notable shifts in our survey responses. Do firms see or anticipate falling revenues or demand? Do their expectations for price changes stop coming back into more normal territory? Do they anticipate slowing hiring or even reducing their workforce? And, to what extent are tight credit conditions impacting their ability to grow or pursue new ventures?

There's no question that we are still working through the imbalances created through the COVID-19 pandemic. I'll continue to pay attention to how firms and households are negotiating that rebalance.

Yeh: As an economist interested in firm dynamics, I'm particularly curious about the aftermath of the COVID-19 pandemic surge in startups. The question is, is this a temporary phenomenon or are we breaking this four-decade long trend of declining startups?

Sablik: That's right, Chen, we had you on to talk about that startup surge earlier in the year, so we'll have to have you back on the show to discuss your new findings when you get those.

Sonya and Chen, thank you both for coming on the show today.

Waddell: Thank you, Tim, it's always good to talk with you.

Yeh: It's always a pleasure.

Sablik: Listeners can visit our website to find the results from the latest CFO Survey, which as Sonya mentioned is released today, as well as links to all the other resources we discussed. And if you enjoyed this episode, please consider leaving us a rating and review on your favorite podcast app.

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