How could tighter bank lending impact growth?

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we consider how the banking crisis will impact the credit channel to the economy. How could a contraction in bank loans lower US GDP? 

 

Need to know Survey data from banks show a tightening of loans granted to economic agents Loans are not impacted uniformly, and before the banking crisis took hold, conditions for housing loans were not particularly more stringent If bank lending standards are tightened, the impact on real GDP could range from -0.25% to nearly -1%, according to US data

 

Is a credit crunch in the cards?

The most recent banking crisis may be behind us, but its main driver remains: high rates but stubborn inflation. In their fight against inflation, however, central banks could well count on a strong, somewhat unwelcome ally: a decrease in bank lending to economic agents.

It is essential at this stage in the cycle to try to measure the potential impact on economic growth of the prospective break in the lending channel that has so preoccupied the European Central Bank (ECB) recently. If the dam breaks, what are the consequences for the economy itself? If our estimates are correct, we may well collectively regret inflation-fighting rate hikes given the potentially negative growth impact of the contraction in bank credit.

 

Loan offers have already started to contract

The starting point of our analysis does not lie on the demand side of the loan market - an equally interesting approach - but on its supply side. As previously mentioned in these columns on a regular basis, the main impact of the March banking crisis is on the macro side rather than the micro side. The credit channel that transmits monetary policy to the economy itself relies on the ability of a central bank to force banks to lend less, raising the cost of credit, increasing the probability of default and lowering the value of the collateral that these same lenders use to finance their banking operations.

With the rise of systemic banking risk, this job has been done, and probably even overdone. The most virtuous banks in the system, those that are best capitalised and most prudent, will now serve as an example to the entire sector, and the supply of loans will inevitably shrink.

Several surveys track the willingness of banks to lend money. In the United States, observers of the macro cycle typically track the Fed Loan Officer Survey, which records and measures the evolution of lending standards. Figure 1 shows the evolution of this survey for different types of loans through January 2023, thus before the impact of the recent banking crisis. By then, banks' willingness to lend money had already deteriorated significantly for most loan purposes: consumer credit, business credit and car loans. Only mortgage lending had not suffered – although one can easily imagine how much mortgage lending could decline in the coming months since the sector has suddenly turned more cautious.

The question now is: what impact on growth?

 

Figure 1. Evolution of bank lending standards (left) and recent compared changes (right)

Source: Bloomberg, LOIM.

 

All eyes on mortgage lending

There are standard econometric techniques for simulating the dynamic impact of an economic series on a group of variables, and we use them regularly in this column (the so-called  ‘impulse response function’). Figure 2 shows the impact of a one standard deviation increase (these values are reported in figure 1) in each Fed Loan Officer Survey on each sub-component of US growth in real terms from 1990 to 2022. Two key conclusions can be drawn from this chart:

• Unsurprisingly, the bulk of the impact of tighter credit conditions falls on residential and nonresidential investment. Regardless of the reason for the loan, investment is the most negatively affected variable. Consumption, on the other hand, is only marginally affected: lending conditions are tightened when the economy is doing too well, reflecting the central bank's command to lend less. In such circumstances, demand does well
• Among the reasons to borrow money, only tightening in one area leads to a decline in all the elements that make up US growth: mortgage lending. Yet this is precisely where the data does not yet show any tightening, as figure 1 illustrates. This could be quite different in the coming months, and is probably the data set to follow in this Fed survey

Historically, a one standard deviation tightening in mortgage lending costs the US economy about 25 basis points of growth over a year. In 2008, the variation of the indicator reached three standard deviations, denting a little less than 1% from real growth in the US. If the supply of housing loans dries up again, the impact should be parallel though its magnitude remains to be measured.

 

Figure 2: Simulated impact of a one-standard-deviation decrease in loan allocation on US growth (in percent)

Source: LOIM, Bloomberg. For illustrative purposes only.

 

Simply put, the banking crisis puts the spotlight on potentially tighter housing loan conditions, which could detract significantly from US economic growth.

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets. 

Our nowcasting indicators currently show:

•    Growth is slowing worldwide but our indicator progresses over the week, as Chinese data show ongoing recovery
•    Inflation surprises should still be negative as our indicator remains at sub-50% levels
•    Monetary policy should reflect a certain moderation in the US and in the Eurozone mainly: a couple more hikes are probably due, but their scale should be limited and in line with expectations  

 

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM's nowcasting indicators gather economic indicators in a point-in-time fashion to measure the probability of a given macroeconomic risk - growth, inflation and monetary policy surprises. The Nowcaster ranges from 0% (low growth, low inflation and dovish monetary policy) to 100% (high growth, high inflation and hawkish monetary policy).

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