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Over the last nine months, we’ve seen U.S. banks tighten credit standards dramatically.

But it’s not just U.S. banks. . .

Eurozone banks have also tightened considerably – their most since the 2011 euro crisis.

Some of the reasons are due to increased funding costs (inverted yield curve), uncertain economic outlook, deposit flight, and sinking loan-to-asset values. (I’ve written more on this before – read here).

Meanwhile, loan demand has weakened – especially in Europe.

So, why does this matter?

Because commercial bank lending is the outlet for credit into the economy (money creation). And since the 1980s, the entire monetary system has been credit-based.

Meaning: take away the credit, and marginal demand and asset prices will sink with it (vice versa with expanding credit).

This is also known as a ‘credit crunch’ – when a sharp drop in the availability of money/credit from lenders leads to systemic fragility.

Thus with banks tightening so aggressively and loan demand further weakening, I believe that growth of all kinds will face downside momentum. And that the risk of a black swan event amplifies.

So let’s take a closer look at what banks are reporting. . .

U.S. Banks Tightening Credit Standards At Their Highest Levels Since 2020 And 2008

Yesterday, the Federal Reserve released its quarterly Senior Loan Opinion Survey (aka SLOOS), an important measure in gauging lending sentiment across the banking sector.

And it showed further net-tightening across all major credit categories – especially in auto lending.

To put this into perspective – take a look at the net percentage of banks tightening credit standards over the last year – Q2-2022 through Q2-2023.

Remember, higher means more tightening, and lower means less tightening.

1. Banks tightening credit to large-to-middle-sized firms rose from -1.5% to 46%.

2. Banks tightening credit to small firms rose from 0% to 47%.

3. Banks tightening credit for credit cards rose from -10% to 30.4%.

4. Banks tightening credit for auto loans rose from -6% to 28%.

5. Banks tightening credit for commercial real estate loans rose from 7% to 74%.

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This is a dramatic tightening in bank lending standards – all at their highest levels not seen outside of the 2008 and 2020 recessions.

And it’s important to note that while bank lending tightened further in the last quarter, it wasn’t as significant as many expected since the recent bank failures.

But as we can see in the chart, banks were tightening aggressively months before Silicon Valley Bank (SVB) even blew up. And I believe this further added to banking stress in the system (I’ve written more on SVB and bank stress – read here).

Even Jerome Powell – the Federal Reserve chairman – recently noted this during a press conference last week.

He said, 

“The strains that emerged in the banking sector in early March appear to be resulting in even tighter credit conditions for households and businesses. . . In turn, these tighter credit conditions are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. . .”

So – it’s clear that loan supply is tightening relatively and increasing economic fragility.

But what about loan demand?

Well, loan demand is looking rather anemic as consumers turn away from higher interest rates and increased debt burdens.

According to the Fed’s recent SLOOS survey – the net percentage of banks reporting stronger demand (i.e. below zero means less demand) remained negative for all major loan categories. (Although credit card demand and auto loan demand slightly rose but still remained negative).

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And this is a problem for both economic and asset prices.

Because borrowing to invest or consume pulls forward marginal demand as firms or individuals spend now where they couldn’t without the debt.

But if individuals and firms scale back credit usage, it does the opposite. It reverts demand to what wages alone can justify.

And while that may sound ‘healthy’ – and it normally is – the issue now is that real wage growth (aka adjusted for inflation) has been negative over the last two years.

To put this into perspective – according to the Dallas Fed – there’s been a surge in both the share of workers seeing negative wage growth and the severity of the real wage declines since 2021.

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This essentially means that individuals have depended on credit to subsidize lower real incomes. (Or to use their pent-up pandemic-era savings – but those are now roughly depleted).

I believe this is a big reason credit card debt ballooned over the last year – rising dramatically and now nearly $1 trillion as of March 2023.

Worse is that this surge in credit card debt happened even in the face of over 20% average APRs (aka the annual percentage rate – the highest ever recorded).

But as we learned from the underrated economist – Hyman Minsky – private debt can’t rise forever.

Eventually, a tipping point will be reached where leverage outpaces capacity and what wages/incomes can justify.

This leads to a painful deleveraging cycle – which is known as a ‘Minsky Moment’ – as debtors must rebalance.

Things like liquidating assets, cutting back credit usage, and focusing on repaying old debts proliferate. Leading to low growth, weak asset prices, and deflation.

Why?

Because just as greater bank lending and consumer borrowing create money. Bank tightening and less borrowing (i.e. repaying debts) destroys money from the system.

But I digress.

The point is that U.S. banks will most likely continue tightening credit over the remainder of the year. And loan demand should continue to slump further anemic. Thus putting pressure on growth and asset prices.

In fact, I’d argue that such sharp bank tightening is the biggest risk factor for a recession as credit evaporates.

And making this matter worse, it’s not just the U.S. banks that are tightening. . .

Eurozone Banks Tighten Credit At Steepest Rate Since The 2011 Euro-Crisis – Meanwhile Loan Demand Plunges

The recent European Central Banks (ECB) bank lending survey painted a grim outlook for lenders as they tighten credit standards at their fastest pace since the 2011 euro crisis.

Because as the ECB hiked interest rates alongside the Fed – raising the overnight rate to 3.75% (its highest level since 2008) – Eurobanks have also tightened credit.

Thus – to put it simply – the same problems plaguing the U.S. banks are mirrored in Europe.

The usual reasons are an uncertain economic outlook, lower risk tolerance, and higher costs.

But most troubling is that euro area loan demand has effectively collapsed.

To put this into perspective, banks reported a net decrease in demand for loans across all four of the largest euro area countries – Germany, Spain, France, and Italy – in the first quarter of 2023.

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For context, the survey showed that 38% of banks in the 20 countries that share the euro reported a decline in demand for credit from companies in Q1-2023. Marking the biggest proportion since the global financial crisis of 2008-09.

Meanwhile, demand for home mortgage loans collapsed further. With a net-72% of banks reporting a decline as households grew pessimistic about the property market.

But making matters worse, euro banks expect that the impact of tighter market financing conditions, declining liquidity positions, and total assets will continue to be negative over the next six months.

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Meanwhile, the tightening impact on terms and conditions and the harsh decline in lending volumes are also expected to continue.

Keep in mind that banks are essentially volume-driven businesses. Thus any decline in lending volumes will negatively affect bank profits – amplifying tighter credit conditions.

And because of this combination between anemic loan demand and tighter credit, euro area weakness will most likely persist.

In fact, such weakness gives the ECB some leeway to hike interest rates by a smaller amount going forward (if they even do at all for much longer).

Why?

Because the commercial banks in Europe are tightening for them (cutting off access to credit in the economy).

And – as I mentioned above – with consumer demand for loans anemic, so will growth and asset prices as marginal buying erodes.

In Conclusion

Banks in the U.S. and Eurozone continue to tighten credit at sharp rates across all loan categories.

But the more worrying trend for growth is the declining demand for loans.

Remember – historically – that as credit supply tightens and consumers cut back on borrowing, it ripples throughout the system and slows the economy.

Or putting it simply – a credit crunch increases fragility and the risk of black swans popping up (such as further bank failures).

Thus I expect slower growth momentum, declining inflation, and greater banking sector issues as long as this tightening trend amplifies.

I really can’t stress this enough.

In a credit-dependent system, borrowing leads to excess demand over what wages can justify. Whether it’s assets or housing or vehicles or retail sales.

Thus take away the credit, take away the upside momentum. 

But as always, time will tell.

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