The Recovery Is Not Credit Dependent

Summary

• As is typical of most recoveries, the credit impulse is currently negative, suggesting a bank credit crunch may impact growth little.
• Only small businesses seem dependent on bank credit, with large banks providing the majority.
• The high concentration of the US banking system limits businesses’ exposure to smaller and riskier banks.

Market Implications

• Markets are overestimating the risks of Federal Funds Rate (FFR) cuts.

Recovery Proceeds Despite Negative Credit Impulse

The ongoing banking crisis has sparked concern a possible credit crunch could crimp US growth. In this note, I discuss the risks.

Chart 1 shows the non-financial private sector (NFPS) credit impulse, i.e., the one-year change in the ratio of NFPS debt to GDP, broken down between banks and other debt holders (e.g., GSE, insurers, mutual funds, etc.). A few facts are apparent:

1. The current recovery is proceeding despite a negative credit impulse. This aligns with previous recoveries: the credit impulse tends to be positive during recessions, as households and businesses bridge their temporary income losses. By contrast, during recoveries, income normalizes and households and businesses have much less need for debt to fund their spending. The credit impulse therefore tends to be negative. Alternatively, the credit impulse can be large and positive during periods of speculative excesses (e.g., the mid-1980s that ended with the S&L crisis or the early 2000s). There was no such excess before the COVID-19 pandemic.
2. The current swing in the credit impulse is unprecedented and likely reflects extraordinary easing by the Federal Reserve (Fed) during the pandemic.
3. Credit expansion in other sectors has sometimes offset past contractions of bank credit, for instance in the early 1980s and 1990s.

We can break down the credit impulse of depository institutions into credit unions and domestic (i.e., US chartered) and foreign banks (i.e., Foreign Banking Offices in the US). Since credit union and foreign bank assets are about 10 times smaller than those of domestic banks, I will concentrate on the latter.

Chart 2 shows the credit impulse provided by domestic banks, broken down between ‘small’ and ‘large’ banks. Large banks are the 25 largest banks, which included Silicon Valley Bank. 

Small banks’ credit impulse has recovered faster than large banks’ this time as it did following the Global Financial Crisis. 

Meanwhile, large banks’ credit impulse tends to be much larger than small banks’, reflecting the concentration of the US banking system. The largest 25 banks represent about 70% of banks assets (Table 1).

Smaller Firms at Higher Risk of Bank Credit Tightening

Table 1, extracted from the Fed’s financial accounts, shows the NFPS funding sources (rows 1­‑4), the key holders (rows 5-15) of NFPS debt, and the different types of NPFS debt (columns A‑G). Row 1 includes only NFPS debt while row 5 includes the assets (=liabilities) of the whole economy, including the financial sector. This is because the financial accounts provide a breakdown of financial assets by sector or by instrument, but generally not by sector and instrument.

The NFPS comprises households, incorporated businesses (i.e., larger firms that average about 60 employees), and unincorporated businesses (i.e., smaller firms that average about 15 employees).

Table 2 shows NFPS liabilities and key funding sources.

NFPS Liabilities

• Loans represent 80% of NFPS debts, which reflects that corporate borrowers can tap financial markets but households and non-corporate businesses cannot (non-corporate businesses include S-Corporation, sole proprietorships, partnerships, and non-profits).
• Private debt securities (munis, CP, and corporate bonds) represent about 60% of corporate debt.
• Mortgages are the most important type of loan for households and non-financial non-corporate businesses (NFNC), but not for corporates.

NFPS Key Funding Sources

• The biggest holders of private debt securities are insurers, mutual funds, exchange-traded funds (ETFs), and foreigners. Banks hold less than 10% of the total.
• The biggest holders of loans are depository institutions, but these account only for about a third of the total. 
• GSE and their mortgage pools are the second largest loans suppliers with a fifth of the total.

In summary, these are the most important source of funding:

• For households, the public sector through the GSEs and their mortgage pools and through government student loans.
• For NFNC (smaller firms), banks.
• For NFC (larger firms), institutional investors (i.e., insurers, pension funds, mutual funds, ETFs, and foreign investors).

Simultaneously, NFNC (smaller firms) do not seem overly exposed to small banks, sometimes considered riskier. NFNC rely equally on residential and commercial mortgages as funding sources. While small banks dominate the latter, large banks dominate the former (Chart 3). 

In addition, the concentration of CRE at small banks is not necessarily a sign of excessive risk taking. Rather, it could reflect that most CRE investment is local and smaller. Local banks have therefore an informational advantage over megabanks.

Limited Macro Risks From a Bank Credit Crunch

The household sector accounts for about 75% of GDP through consumption and residential investment. Most household borrowing comes from GSEs and the government (through student loans) and therefore would be affected little by a bank credit crunch.

Businesses account for about 15% of GDP through non-residential investments and impact consumption through employment. Census data shows that non-corporate non-financial businesses account for about 60% of private non-financial employment. In addition, the JOLTS data shows firms below 50 employees, which includes most NFNC, account for 60% of all hires (Chart 4).

However, the US banking system is so concentrated that large banks already account for most business lending.

Market Consequences

Slower growth in bank credit is likely, following recent events. However, the above analysis suggests it may do little to slow growth and inflation.

Meanwhile, the Fed has signalled its intent to hike once more this year then pause. Even if inflation does not slow, the Fed may not hike more until it is confident that a credit crunch will not cause a hard landing.

Against this, markets are pricing about 60bp of cuts, which is unlikely.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)