FRBSF Economic Letter
2002-12; April 26, 2002
Is There a Credit Crunch?
Western Banking Quarterly is a review of banking
developments in the Twelfth Federal Reserve District, and includes FRBSF's
Regional Banking Tables.
It is normally published in the Economic Letter on the fourth Friday
of January, April, July, and October.
Recently, some concerns about a "credit crunch" in the U.S.
economy have appeared in the business press. In the commercial paper market,
a number of large firms were reportedly unable to borrow from this market,
as investors reassessed the credit risk of these firms amid growing accounting
concerns. In the bank loan market, total commercial and industrial (C&I)
lending has fallen quite substantially. Business credit is the lifeblood
of economic activity, so it is very important that the credit market function
properly and smoothly. This Economic Letter examines recent developments
on credit availability to businesses, focusing specifically on the issue
of a credit crunch, or credit rationing, in which creditworthy borrowers
are denied credit.
The commercial paper market
Commercial paper—short-term, unsecured promissory notes issued by corporations—is
a low-cost alternative to bank loans. In order to offer commercial paper
at competitive rates, the issuers must be large and reputable firms, so
that institutional investors can trust in their creditworthiness. The
market for nonfinancial commercial paper has grown rapidly in recent years,
peaking at $351 billion in November 2000. Since then, it has fallen over
40% to about $200 billion. While some of the recent drop-off was related
to the well-publicized problems faced by a few large companies that could
no longer tap the commercial paper market, the decline started much earlier.
Part of the decline is due to the softening demand for short-term financing
as economic activity slowed in early 2001. Indeed, the current downturn
in commercial paper started just a few months before the economy went
into a recession.
It is important to gain some perspective on the recent instances where
a number of large firms were shut out of the commercial paper market.
In providing very short-term, unsecured financing, commercial paper investors
place a high value on safety, and they deal almost exclusively with only
high-quality borrowers. Thus, whenever there is even a small doubt about
a firm's creditworthiness, investors simply bypass this firm's commercial
paper altogether. At the same time, it may not be economical for the firm
to raise its commercial paper yield to entice investors, as the firm may
find it cheaper to borrow from a specialized lender like a bank, which
usually provides back-up lines of credit to commercial paper issuers.
Thus, the recent episode reflects more about how the commercial paper
market works than about an environment of unusual credit rationing. So
far, there is little evidence to suggest that high-quality borrowers cannot
access this market.
In addition, the interest rate on high-grade commercial paper continues
to track the default-free Treasury rate very closely. Thus, there is no
sign that high-quality borrowers have to pay more on commercial paper
financing. Nevertheless, the spread between the highest grade and the
second-tier commercial paper has widened somewhat recently. This may be
due to the heightened sensitivity to credit risk in this market amid growing
concerns about accounting practices and transparency among several large
commercial paper issuers. Overall, the relatively small interest rate
differentiation in the commercial paper market again suggests that only
high-quality borrowers can access this market.
Bank C&I lending
In the bank loan market, commercial banks also have been tightening their
standards for C&I lending to both large and small borrowers for quite
some time, as indicated in the Federal Reserve Senior Loan Officer Opinion
Survey (2002). At the same time, the survey also points to falling loan
demand faced by banks amid a slowing economy. With both supply and demand
factors at work, seasonally adjusted bank C&I lending has fallen 7.5%
to around $1 trillion since the recession started (Figure 1), a much steeper
decline than in prior recessions.
At issue in determining whether there is a credit crunch is what is happening
on the supply side. Specifically, are the tighter lending standards a
response to the changing creditworthiness of the borrowers, or are they
driven by something else? Tightening in response to declining repayment
capability of the borrowers is a rational business decision that is the
key to a healthy banking sector; however, tightening that is unrelated
to the borrowers' fundamentals is a cause for concern. So far, the evidence
seems to suggest the former, not the latter.
First, the C&I loan delinquency rate has been climbing steadily since
2000 and shows signs of acceleration towards the end of 2001 (Figure 1).
Part of the pickup in loan defaults has to do with banks' lax lending
standards during the boom years. Thus, facing a growing bad loan problem,
it seems logical for banks to rein in their lending standards to be more
in line with economic fundamentals. Second, the slowing economy was expected
to worsen borrowers' repayment capability going forward. Indeed, the Loan
Officer Survey indicated that concerns about the economic outlook were
the main reason banks tightened their lending standards. Hence, while
some borrowers may see their credit rating downgraded by banks and must
incur higher borrowing costs, other marginal borrowers would no longer
meet the bank's minimal lending standards and must be denied credit. Quite
clearly, this kind of tightening is a rational response to the borrower's
changing condition and should not be confused with credit rationing. Third,
banks in general are highly profitable and have strong capital positions.
Unlike the early 1990s, when banks restrained lending due to low capital,
now we do not seem to see readily identifiable supply factors in the banking
industry that may cause banks to refuse to lend to creditworthy borrowers.
Finally, data on total credit flows indicates that, while C&I loans
and commercial paper volume are contracting, total business debt is still
growing at a healthy pace. In particular, Figure 2 shows that the decline
in bank lending is more or less offset by the robust credit extension
by other lenders, including finance companies, long-term bond holders,
as well as real estate and other asset-based lenders. This was not the
case in prior recessions.
The significant drop-off in nonfinancial commercial paper and the sharp
decline in bank C&I lending have raised concerns about credit availability
to business borrowers. But so far, there is no indication that truly creditworthy
borrowers cannot obtain credit, as evidenced by the healthy growth in
total business debt. The declines in commercial paper and C&I lending
both coincided with slowing economic activity and are consistent with
falling demand for short-term credit by businesses. To the extent that
firms that were squeezed out of the credit market are indeed marginal
borrowers, this is nothing more than normal market forces at work.