Why Banks Are Slowing Lending to Business or ‘A Rolling Loan Gathers No Loss’: Has the Monetary Policy-Credit Channel Weakened?

Abstract

Why is bank lending to business for their own portfolios slowing? This study analyzes six reasons for banks’ willingness or inability to lend to commercial and industrial and real estate businesses. Their willingness (or unwillingness) stems from a combination of bad loans on their books and fear on behalf of our bank regulators that lending to business in a slow and recovering economy is “too” risky. As we will show, banks are flush with funds and should be able to make loans in their respective markets. Since banks face low borrowing costs, in some recent cases at virtually zero, they have chosen to invest in U.S. Treasury securities with no default risk. In addition the interest payments to banks for their required and excess reserves has now increased to 2.20 percent as of September 27, 2018, 20 basis points above the lower range of the Fed Funds target rate. Normally the effective Fed Funds rate is very near the mid-point of the target range, between 2 to 2.25 percent. Banks have a decision: Why make risky loans to businesses when government regulators encourage banks to risklessly invest in reserves earning 2.20 percent? This is a particularly attractive alternative if deposit rates are very low. However, now that the Fed has abandoned its QE policy, rates on deposits are rising so that banks may be less satisfied with the 2.20 percent rate on bank reserves. Might we see bank lending to business increase as the Fed continues to raise rates? We make three solid recommendations based on our analysis of the 6 reasons bank lending is slowing: 1. Encourage regulators to be more lenient by allowing banks to amortize write downs of nonperforming loans over a 5 year period. 2. Congress should eliminate the prepayment penalty banks must pay the Federal Home Loan Banks on advances. 3. The Federal Reserve should phase out the interest payments on reserves to a level that will not encourage banks to choose investment in reserves over loans to business. And 4. Bank regulatory policy should move to ease the regulatory pressure to “play it safe.” These all mean that banks must use the resources they have accumulated to begin to make loans to small and medium size business to create jobs and contribute to economic growth. The study uses a data set that incorporates bank balance sheet and income statement data aggregated from the banks’ quarterly reports of Condition and Income from Q1 1984 to Q4 2017. These data have not been used in previous studies and, although aggregated, they provide a unique picture of the entire banking system. These data enhance the credibility of our results along with the considerable explanatory power of our interactive regression approach to analysis.