Will US banks lend more to firms? – BMO CM

U.S. bank loans to companies have surprisingly weakened this year, despite an upswing in investment as growth in commercial and industrial loans by banks slowed from double-digit rates in early 2016 to 2.0% y/y in Q3, the weakest since 2011, points out the research team at BMO Capital markets.

Key Quotes

“The downshift is jarringly similar to that of past economic downturns, despite current buoyant conditions and confidence. But, unlike past recessions, business investment is strengthening rather than weakening. It rose nearly 5% in the past year to Q3, and looks to climb further in Q4 amid rising capital goods orders.”

“There are several reasons for the seemingly counterintuitive slowing in bank lending to business in a macro environment where investment is rising:

• Mind the lag: The correlation between business investment and loan growth rises materially when investment is advanced three quarters. Some of the recent slowing in loan growth likely reflects last year’s slump in capital spending, notably in the energy sector. So, it might just be a matter of time before bank lending responds to the recent upturn in investment.
• Higher interest rates: The Fed has raised rates four times in two years and intends to push rates higher in the years ahead. While borrowing costs are far from high (or even neutral), they are expected to rise further. That could be a concern for some highly leveraged companies, with nonfinancial corporate loans and debt securities at a record 45% of GDP.
• No thanks, I’m fine: Many companies do not need to borrow to finance spending as cash holdings and profit margins are near all-time highs.
• Alternative funding sources: Companies that are borrowing are tapping bond markets due to generous credit spreads. In fact, financing from non-depository institutions, mainly through syndications, alternative finance companies, private equity and asset-backed security issuers, has soared over 11% in the past year (to Q3). Investors are more than eager to buy higher-yielding securities. Indeed, the ascension of Collateralized Loan Obligation funds, which fall outside the purview of certain Dodd-Frank asset-backed security regulations, has granted greater investor access to these risk pools and, in turn, greased lending activity in the space. This is not all bad for banks. While traditional bank loans to business have slowed, fee business is on the rise as banks facilitate alternative credit channels, namely syndicated loans and corporate bond underwriting.
• Nervous Nellie: Ongoing concerns and uncertainty about trade protectionism (amid souring NAFTA talks) and tax reform legislation likely have some companies sitting on the fence. 
• Tougher lending standards: After relaxing credit standards in the six years after the recession, banks turned cautious in 2016, notably for energy companies wrestling with lower prices. While loan standards have relaxed in recent quarters, they likely remain more restrictive than in 2015.” 

“Outlook for Bank Credit to Business

• Despite the recent deceleration, bank lending to business is expected to find near-term support from the upturn in capital goods investment and the recent easing in lending standards. Meantime, firmer oil prices should encourage renewed interest in energy sector lending. The potential for a lighter regulatory touch for banks could also unleash further funds for business. On the flipside, growth prospects will continue to be restrained by the relative attractiveness of debt market financing, the increasing role of non-depository lenders and the rising interest-rate environment.” 

“Bottom Line: While an improved economic backdrop has yet to translate into an upturn in business credit from banks, conditions should remain constructive in 2018, even if uncertainty about government policies and an increasingly competitive funding environment persist. We expect U.S. business credit growth to remain strong at near 6% in 2018, with banks sharing in the gain.”