Elizabeth A Duke: A framework for analyzing bank lending
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the US Federal
Reserve System, at the 13th Annual University of North Carolina Banking Institute, Charlotte,
North Carolina, 30 March 2009.
The original speech, which contains figures and various links to the documents mentioned, can be found on the
US Federal Reserve System's website.
* * *
In August 2008 I joined the Board of Governors of the Federal Reserve System, leaving
behind a 30-year career as a commercial banker to become a central banker. My time as a
commercial banker spanned numerous business cycles. It also encompassed at least one
severe financial system crisis, in the late 1980s through the early 1990s, albeit one that was
not as severe as the current one. From my time as a commercial banker, I already
understood the factors considered by bankers in the initial lending decision as well as those
in loss mitigation when collecting those same loans. As a central banker, I have come to
appreciate even more fully the role of credit in our economic well-being. So I thought it would
be appropriate for me to provide my perspective on credit conditions in our economy and the
current crisis.
Today, I would like to discuss a three-dimensional view of the flow of credit to households
and businesses and describe the evolving role of banks in the U.S. economy. I will begin by
taking a look at recent trends in aggregate borrowing by households and by the nonfinancial
business sector. These trends will be placed in a historical context by looking back at
previous booms and busts in the credit cycle. One might call this the "macroeconomic view"
of credit. When looking at aggregate borrowing, it is important to remember that a change in
debt outstanding can be driven by any one of three factors or, more commonly, a
combination of all three. In the macroeconomic view of credit, I will discuss indicators related
to changes in demand for credit. I will also examine two determinants of the supply of credit.
The first determinant relates to lenders' assessment of the creditworthiness of borrowers
given future economic conditions. The second relates to credit constraints caused by the
financial condition of the lenders. Although fiscal and monetary policies that improve
macroeconomic conditions will also boost the demand for credit and improve the
creditworthiness of borrowers, if credit is constrained by the balance sheets of the banks,
only programs to relieve such strain will improve credit availability. This condition is the
reason for the injections of capital into banks through the Troubled Asset Relief Program, or
TARP, and the financing provisions offered through the Public-Private Investment Program,
or PPIP, as well as the expansion of Federal Deposit Insurance Corporation (FDIC) deposit
and nondeposit guarantee programs.
Next, I will consider the providers of credit. Using the Federal Reserve's flow of funds data, I
will look at the evolution from 1950 to 2008 in the market shares of financial intermediation
for banks, thrifts, insurance companies, and "other" firms, which range from finance
companies to the entities that issue asset-backed securities (ABS). Although these data
could suggest that the importance of banks has significantly diminished, I will argue that it
matters how we measure what banks have been doing. In particular, it is important to take
into account the off-balance-sheet activities of banks when securitization became more
pervasive and when it abruptly stopped. This "financial intermediation view" of credit, in my
opinion, illustrates the importance of supporting the availability of all forms of lending,
whether it be on-balance-sheet lending by banks, credit originated by banks and securitized
and sold to investors, or credit supplied by nonbank lenders.
The Federal Reserve has long served as a lender to banks, providing them with liquidity to
maintain lending in times of stress. Over the past year and a half, however, the Federal
Reserve has greatly expanded its provision of liquidity, establishing facilities under which we
auction term funding to banks on a secured basis, provide liquidity to primary dealers and
money market mutual funds, and supply credit to issuers of commercial paper. In addition,
through our purchases of agency debt and mortgage-backed securities, the Federal Reserve
is lowering the cost of borrowing for mortgages as well as creating an outlet for loans that are
originated by banks and nonbanks and securitized by the agencies.1 Most recently, the
Federal Reserve, in conjunction with the Treasury, has established the Term Asset-Backed
Securities Loan Facility, or TALF, which uses capital provided by the Treasury in combination
with liquidity provided by the Federal Reserve to enhance the availability of credit to
households and businesses.
Because banks remain central to financial intermediation, they deserve a closer look,
particularly during this time of financial-sector turmoil. In my discussion of the "banking view"
of credit, I will summarize the current state of the banking industry. As you know, banks play
a special role in just about every economy in the world, and the United States is no
exception. Banks' liabilities are generally more liquid than their assets. They are also the
main repositories of deposits, which provide immediately available liquidity to households
and businesses and are used to undertake transactions for goods and services. In addition,
banks provide intermediation between borrowers and savers. Indeed, banks remain the
principal source of finance for a large part of the economy. Given these important and
distinctive functions, it is, perhaps, obvious that adverse shocks to the financial system and
the banking industry can have detrimental effects on economic activity. The current financial
turbulence, like several similar events in the past, has placed severe strains on the U.S.
banking system with serious repercussions for the economy as a whole.
The "macroeconomic view" of credit
Looking back over the past 50 years or so, credit extended to households and businesses
has almost always declined just before, and during, economic downturns. And almost as
often, a debate has ensued about whether the nation was in a "credit crunch."2 According to
the White House Council of Economic Advisers, "a credit crunch occurs when the supply of
credit is restricted below the range usually identified with prevailing market interest rates and
the profitability of investment projects."3 Judging whether a credit crunch is happening in real
time is not easy. It is extremely difficult to sort out the relative importance on the flow of credit
of reduced demand due to weaker economic activity, reduced supply because borrowers
appear less creditworthy, or reduced supply because lenders face pressures, such as a
shortage of capital, that restrain them from extending credit. In other words, while demand
considerations could certainly result in a decline in credit flows, a reduction in the supply of
credit - caused either by bank balance sheet pressures or by banks reluctant to lend to
lesscreditworthy borrowers - could produce the same result.
Figure 1 presents annualized quarterly percent changes in debt growth for home mortgages
in the United States from 1952 to 2008, with shaded areas denoting National Bureau of
Economic Research recession periods. Strikingly, the quarterly rate of growth for home
mortgage debt, which includes mortgages and drawn-upon home equity lines, has typically
declined before and during each recession and then picked up when economic conditions
improved. What is different this time around is the runoff in home mortgage debt: It declined
in the fourth quarter for the first time in more than 50 years. The recent decline in mortgage
debt was likely partly driven by weaker demand for housing amid rising unemployment and
rapidly falling home prices.
It is equally likely that supply-side considerations have played a role. First, the run-up in
mortgage delinquency rates and the higher loss rates associated with reductions in collateral
values indicate that the creditworthiness of borrowers has declined. The unprecedented
increase in mortgage defaults has resulted in more foreclosures and tighter mortgage lending
terms, which are shown from 1990 onward in figure 2. Although the net fraction of banks
tightening lending standards on mortgage loans was about 50 percent in our most recent
Senior Loan Officer Opinion Survey on Bank Lending Practices, it should be noted that most
banks had already tightened their lending standards substantially in 2008. Second, the
shutdown of the private mortgage-backed securities market has placed greater pressures on
bank balance sheets not only to provide credit to borrowers with damaged credit histories,
but also to provide so-called jumbo mortgages that are originated in amounts that are over
the conforming loan limits applicable to loans sold to or guaranteed by the
governmentsponsored enterprises (GSEs) Fannie Mae and Freddie Mac and by Ginnie Mae. Of course,
credit provision to some borrowers was helped through mortgage insurance programs
offered by the Federal Housing Administration, which were recently expanded by the
Congress through increases in coverage levels. Similarly, other borrowers have been able to
qualify for mortgages that became eligible for securitizations by the GSEs because of
increases in conforming loan limits. Indeed, as the non-agency mortgage-backed security
market contracted by roughly 15 percent in 2008, Ginnie Mae increased its outstanding
supply of single-family mortgage-backed securities by roughly 33 percent. Even with the
growth of such securitizations, banks still needed to expend some balance sheet capacity to
warehouse loans on their books prior to securitization.4
In response to these supply-side developments, the Treasury, the FDIC, and the Federal
Reserve have encouraged banks to work with existing borrowers to avoid preventable
foreclosures.5 The Federal Reserve and the other banking agencies also have encouraged
banking organizations to participate in the Treasury's Home Affordable Modification
Program.6 Doing so should help to stem the runoff in mortgage debt and to damp the added
downward pressure on house prices that can occur when neighborhoods have clusters of
foreclosed properties. In addition, the Treasury's Capital Assistance Program, the FDIC's
Temporary Liquidity Guarantee Program, and the Federal Reserve's programs to provide
liquidity are intended to help ease the funding and balance sheet pressures banking
organizations face, thereby allowing them to undertake responsible lending activities,
including new mortgage originations.
I will now turn to nonmortgage consumer credit, which is shown in figure 3. The growth rate
for consumer credit has been trending down, on balance, for years, but it remained quite
robust until the latter half of last year. Indeed, consumer credit fell quite sharply in the fourth
quarter. Looking back over the past 50 years, nonmortgage consumer credit typically
weakens throughout a recession as labor markets deteriorate and often turns down even
after the recession ends. Thus, history suggests that consumer credit growth will likely slow
further in the near term; in addition, many banks have tightened terms and standards for
nonmortgage consumer loans.
Turning to the business sector, and in particular the corporate sector, the major components
of borrowing are bonds, commercial paper, commercial mortgages, and commercial and
industrial bank loans. As shown in the left panel of figure 4, gross bond issuance for
investment-grade firms increased in the fourth quarter of last year from a very weak third
quarter and seems to have increased further in the first quarter of this year as firms appear to
have strengthened their balance sheets by shifting toward longer-term debt. In contrast,
speculative-grade bond issuance has remained sluggish.
In September 2008, nonfinancial corporations' commercial paper outstanding contracted (the
black solid line in the right panel of figure 4), as money market mutual funds - ordinarily
major investors in commercial paper - faced significant strains. Losses on Lehman Brothers
paper led one prominent fund to "break the buck" - that is, to fail to maintain a net asset
value of $1.00 a share - which undermined investor confidence in such funds and triggered
significant withdrawals from funds that typically invest in private-sector debt. In response, the
Treasury established an insurance program for money market mutual fund investors, and the
Federal Reserve introduced new programs to provide liquidity to money market mutual
funds. In addition, the Federal Reserve authorized the Commercial Paper Funding Facility to
provide a liquidity backstop for U.S. issuers of commercial paper.7 These programs helped to
restore confidence in money market mutual funds and improve the functioning of the
commercial paper market. By early this year, the strains in the commercial paper market had
eased notably.
The volume of bank lending in 2008 mirrored developments in the commercial paper market.
In the fall, bank commercial and industrial lending surged for a time (the red dotted line in the
right panel of figure 4), reportedly reflecting, in part, substantial draws on previously existing
long-term lending commitments; then such lending contracted sharply as access to other
sources of funding, such as commercial paper, improved. In this manner, bank loans
provided at least a partial substitute for market-based funding until market functioning
improved. That said, the growth rate for debt of nonfinancial businesses decreased sharply in
2008.
As shown in figure 5, debt growth for nonfinancial corporate businesses reached almost 15
percent at the peak of the business cycle in December 2007, but it was less than 3 percent
by the end of 2008. Looking back, it is apparent that debt growth for nonfinancial corporate
businesses can, and often does, decline sharply as the economy slows. During recessions,
which are indicated in the figure by shading, debt growth has typically decreased and
sometimes even become negative, such as during 1990-91. In part, such declines in debt
growth are derived from declines in demand for the goods and services produced by
nonfinancial firms. In addition, such declines reflect the ongoing tightening of lending
standards that can result from the deterioration of the fundamentals that support lending.
Turning to commercial mortgage growth, figure 6 presents such data from the 1950s through
2008. As with the debt series plotted in previous charts, commercial mortgage growth
typically drops off during a recession as retail sales slow and less office space is needed for
workers. Especially striking is the prolonged contraction in commercial mortgages
outstanding after the 1990-91 recession. Since the peak of the recent business cycle,
commercial mortgage growth has slowed with each passing quarter. By the fourth quarter of
2008, its annualized growth was only about 1 percent.
The "financial intermediation view" of credit
The commercial paper market example, which I briefly described earlier, highlights the fact
that financial intermediaries can play an important safety-valve role for the financial system.
When the commercial paper market suddenly dried up, financial intermediaries were able to
fund firms that had unused lines of credit or other commitments.8 Moreover, the Federal
Reserve, through its lending programs, contributed to improved conditions in the commercial
paper market so that issuance of these short-term funding instruments could resume.
In today's economy, much of the flow of credit comes from lending that occurs outside of the
banking system. Here again, it is useful to take a historical look at financial intermediation to
better understand the potential effect on the availability of credit to households and
businesses from the recent shutdowns in the securitization and commercial paper markets
and to get a first glimpse at how financial intermediation markets responded.
Consider, for example, the shares of commercial mortgages outstanding - funded by
depositories, insurance companies, other financial institution, and commercial
mortgagebacked securities (CMBS) - presented in figure 7. The share funded by CMBS (the orange
line) increased from almost nothing in 1990 to almost 30 percent in 2008. In an accounting
sense, most of this increase in funding from the capital markets came at the expense of
direct holdings of whole loans by insurance companies (the dashed green line) and other
intermediaries (the black line), whose funding shares fell by half between 2000 and 2008. In
contrast, depositories' share of commercial mortgages outstanding (the purple line) held
steady from 1990 through 2007. In 2008, the decrease in the commercial mortgages funded
by CMBS - the downtick of the orange line at the end of the sample - was offset by an
increase in commercial mortgages funded by depositories - the uptick of the purple line.
These data suggest that depositories increased their share of commercial mortgages as
securitization markets stalled in 2008. Again, banks and other depositories served an
important safety-valve function for the commercial mortgage market.
In figure 8, Federal Reserve flow of funds data are used to construct market shares of all
financial intermediation provided by four major classes of institutions: banks, thrifts,
insurance companies, and "other financial intermediaries," which range from finance
companies to the entities that issue ABS.9 In 1950, banks' share of financial intermediation
(the red line) was about 50 percent; it declined and then rose to about 48 percent in the
mid1970s, then it trended down to about 33 percent at the turn of the century. From the fourth
quarter of 2007 to the fourth quarter of 2008, this measure of total financial intermediation
grew by about 5 percent. At the same time, the banking system's share increased from 32.8
percent to 33.4 percent - a 0.6 percentage point increase in market share. Thrifts and
insurance companies - represented by the blue solid and green dashed lines, respectively -
had declines in their market shares in the fourth quarter of 2008.
In figure 9, the shares for banks and thrifts are combined so that there is a depositories'
share of this measure of U.S. financial intermediation (the purple line). Comparing the purple
line for the depositories' share with the black line for other financial intermediaries' share, it is
apparent that these lines mirror one another. Although both of these shares equaled 40
percent in 2001, by the end of 2008, the other financial intermediaries' share had increased
to 45 percent, but the depositories' share had decreased to 38 percent. Interestingly, the
shares for other financial intermediaries and for depositories continued their respective
upward and downward trends despite the disruptions in securitization and financial markets
during 2008.
Turning back to banks, the standard market shares of financial intermediation reported in
figures 8 and 9 neglect their off-balance-sheet activities. Such off-balance-sheet
intermediation has generated considerable earnings for banks. For example, banks receive
fees for lines of credit regardless of whether borrowers use the lines of credit. In addition,
securitization activities have provided many benefits to banks. Even when banks have not
securitized the loans, such as when mortgages were securitized by the GSEs, banks often
originated and serviced the loans that were pooled and have earned fees in the process. If
one adjusts the financial intermediation data for banks to include "credit equivalents" for the
off-balance-sheet activities of banks, then the adjusted market share of financial
intermediation for banks would remain above 40 percent in recent years.10 These adjusted
financial intermediation data are shown using the red dashed line in figure 10.11 With the
near shutdown in securitization markets, adjusted bank assets declined from almost 45
percent in fourth quarter 2007 to 42 percent in fourth quarter 2008. Even with this decline,
however, banks' adjusted share of financial intermediation would be in the higher end of the
range observed since the 1980s.
These adjusted financial intermediation data, however, do not tell the full story. Ideally, we
also would want to adjust the data for all of the other financial intermediaries to include credit
equivalents for their off-balance-sheet activities. Unfortunately, the data do not exist to make
such an adjustment. Nor do the data generally exist to convert the fee income that financial
intermediaries generate by off-balance-sheet activities into balance-sheet equivalents. That
said, the adjusted flow of funds data suggest that banks have remained important financial
intermediaries despite the growth (and disruption) in securitization activities and the arrival of
new competitors.
The "banking view" of credit
Even though the total provision of financial intermediation services by banks remained high
relative to other financial intermediaries and their on-balance-sheet financial intermediation
services increased in the fourth quarter of 2008, it must be recognized that there are many
types of banks in the United States with different specializations, geographic concentrations,
and comparative advantages. Consequently, the extraordinary stress in the financial system,
the downturn in the U.S. and global economies, and the associated reductions in asset
values have affected each bank differently.
Much attention has been focused on the negative loan growth of the largest five bank holding
companies in the fourth quarter of 2008 - about negative 16 percent at an annual rate on a
merger-adjusted basis. The next 20 largest bank holding companies had a notably smaller
decrease in loans over the same period - about a negative 4-1/4 percent rate of decline -
and other (smaller) bank holding companies increased their lending at about a 5 percent
pace. This loan growth may reflect that smaller banks in strong financial condition are finding
that they can gain creditworthy customers - even in the current economic environment - as
other banks cut back on lending to conserve capital and liquidity. Smaller banks may also be
finding opportunities to reclaim consumer and business customers from nonbank competitors
who have pulled back as the securitization markets have dried up.
A decomposition of changes in loans held on bank balance sheets across banking
organizations in the three size groups provides a glimpse into how diverse the portfolio
changes were across banks in the fourth quarter of 2008.12 Figure 11 presents balance sheet
changes for loans held by the banking organizations in all three size groups. The heights of
the red bars indicate declines in loan categories measured in billions of dollars, and the
heights of the blue bars indicate increases in loan categories, also measured in billions of
dollars. For each bank-size group, the bars within the panel add up as one looks from left to
right, so that the total dollar-value change in lending is measured either by the bottom of the
bar (if loan growth, on net, is negative) or by the top of the bar (if loan growth, on net, is
positive). The number at the bottom (or top) of each bar provides the net decrease (or
increase) in loan amounts as one adds the changes from left to right within a bank-size
category.13
The left panel of figure 11 contains changes in loans (on a merger-adjusted and seasonally
adjusted basis) held on the books of the largest bank holding companies, which together
ended the quarter with $6.4 trillion of balance sheet assets. These firms reduced their loan
holdings by about $119 billion, which is indicated at the bottom of the right-most bar in the
left panel. Declines were substantial in commercial and industrial loans ($19 billion), real
estate loans ($47 billion), and consumer loans ($13 billion).
The middle panel of figure 11 contains loan changes for the next 20 largest banking
organizations, which together ended the quarter with about $5.2 trillion of balance sheet
assets. Together, these organizations increased their commercial and industrial loans (by $3
billion), real estate loans (by $7 billion), and consumer loans (by $4 billion) as of year-end
2008. That said, the category of "other loans and leases" fell by more than enough to offset
those increases. Total loans held on the balance sheets of banks in this group decreased by
about $9 billion over the fourth quarter.
The right panel of figure 11 presents the increases in loans held by banking organizations not
included in the largest 25. These organizations ended the quarter with $3.3 trillion of balance
sheet assets. These entities increased their holdings of commercial and industrial loans (by
$4 billion), real estate loans (by $17 billion), and consumer loans (by $9 billion). On net, bank
holding companies and banks in this size class increased their lending by about $27 billion -
far less than the reductions in lending at banks in the larger-size groups.
Within real estate loans, residential mortgage holdings by banking organizations declined
sharply over the second half of 2008. In part, this decline reflected a slower pace of
originations owing to tighter lending standards and weaker demand. But this decline also
reflected the fact that banks continued to originate and sell mortgages to the GSEs as this
securitization mechanism has continued to function. In contrast, home equity loan growth has
recently been brisk as borrowers tapped their existing lines of credit. Unlike mortgage loans,
home equity loans tended to remain on bank balance sheets. Abstracting from a couple of
bank restructuring events, growth in consumer loans - the other category of household
lending - was weak in the fourth quarter, in line with lackluster retail sales and declines in
consumer confidence. Originations may pick up as the TALF gains traction and ABS can be
issued that are collateralized with such loans.14
Turning to business lending, commercial and industrial lending, which, as previously
discussed, had surged during the period of particularly acute financial stress in September
and October, was very weak during the fourth quarter, and commercial mortgage holdings
remained flat.
Changes in the liabilities of banks were equally diverse across the three banking organization
size groups. Figure 12 has the same format as figure 11, with each red bar indicating a
decline in a liability type and each blue bar indicating an increase in a liability type. As with
figure 11, the data are merger-adjusted and seasonally adjusted. The figure presents
changes in core deposits; large time deposits, which are deposits in denominations greater
than $100,000; other managed liabilities; and other liabilities. Other managed liabilities
mostly consist of foreign-booked deposits, demand notes issued to the Treasury, other
borrowed money, and federal funds purchased and securities sold under repurchase
agreements. Other liabilities are noninterest earning liabilities such as trading liabilities.
Numbers at the top and bottom of each bar within a panel represent the sum of liability
changes as one looks from left to right. As with lending growth, the growth in core deposits at
U.S. banking organizations was likely influenced by both demand-side and supply-side
considerations as well as by government policies implemented to improve financial
conditions.
Core deposits, which consist of the sum of transaction deposits, savings deposits (including
money market deposit accounts), and small time deposits issued in denominations of less
than $100,000, expanded at banking organizations of all sizes in the fourth quarter. In part,
this deposit growth reflected lower opportunity costs of holding monetary assets as declines
in market rates outpaced those on core deposits. In addition, this growth was likely
influenced by the increases in deposit insurance coverage that were announced in October
2008.15
Deposit growth also likely reflected bank-led initiatives to increase their deposit funding in
order to reduce their reliance on managed liabilities, such as large time deposits and
borrowings from the Federal Home Loan Banks, and also to fund future lending
opportunities. This substitution of deposits for managed liabilities was particularly
pronounced at the 25 largest banking organizations: These banking organizations reduced
the category of "other managed liabilities" by about $120 billion. In contrast, banking
organizations not included among the largest 25 increased their other managed liabilities by
$30 billion (although managed liabilities are, in general, a smaller fraction of these banks'
overall liabilities).
Conclusion
Today, we have taken a three-dimensional view of the flow of credit to households and
businesses and described the evolving role of banks in the U.S. economy. The
macroeconomic view of credit highlighted the importance for the flow of credit of reduced
demand due to weaker economic activity, reduced supply because borrowers appear less
creditworthy, and reduced supply because lenders face pressures that restrain them from
extending credit. The financial intermediation view of credit highlighted that banks have
remained important financial intermediaries long after the originate-to-distribute model for
funding credit became the dominant model and can play an important safety-valve role for
the financial system. Finally, the banking view of credit emphasized that there are many
types of banks in the United States, and the extraordinary stress in the financial system, the
downturn in the U.S. and global economies, and the associated reductions in asset values
have affected each bank differently. As such, some banks have likely fulfilled the credit
needs of consumers and businesses that had been turned away by their peers. For all of
these reasons, the Federal Reserve is committed to employing all available tools to promote
economic recovery and to preserve price stability.
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