The Next Macro-Financial Risk: Credit Tightening Not Crisis

Summary

• In this note, I show that the data does not validate fears of systemic credit weaknesses:
  • Large businesses are in good financial shape, in part due to record profits.
  • By contrast SMEs and low-income households are struggling, which is reflected by rising delinquency rates in specific loan segments.
• Banks, however, have managed their risk well, remain well capitalized and stand to benefit from regulatory easing.
• With pockets of credit weaknesses likely to persist, more negative credit events are possible, which could lead to a tightening of credit standards.
• Since the recovery is not dependent on credit, tighter standards would have only a limited impact on growth.

Market Implications

• I expect two more Fed cuts in 2025, in line with market pricing, and three in 2026 against market pricing two-and-a-half more.

Private Sector Deleveraging

In this note, I argue that recent credit events are more likely to reflect pockets of weaknesses rather than systemic weaknesses (Table 1). Nevertheless, more credit events are possible and could lead to a tightening of credit standards.

High-yield spreads have compressed to near their lowest levels in four decades (Chart 1). These seem inconsistent with recent high profile bankruptcy filings and with underperformance of regional banks and Business Development Companies stock (both lend mainly to SMEs, Chart 2).

In reality, the data shows that banks and their borrowers are, on average, in good financial shape. Since the pandemic, private leverage has been falling, by contrast with public leverage that has been rising (Chart 3). Relative to GDP, Treasury debt is now higher than at the end of WWII.

Large non-financial businesses’ leverage is high by historical standards, but the corporate bankruptcy index does not suggest underlying weaknesses (Chart 4). The index measures bankruptcy activities for corporations with at least $50mn in reported liabilities. Its current value is in line with expansion average over the past 25 years.

This is in line with record corporate profits, both in real terms and relative to GDP (Chart 5).

Large businesses, however, have become more reliant on private credit for their funding (Chart 6). During periods of financial stress this could turn out to be a weakness since providers of private credit do not fund with deposits and do not have access to Fed liquidity. Instead, they fund themselves through markets and banks.

On the other hand, private lenders are not subjected to the same regulatory strictures as banks and tend to have a closer relationship with their borrowers. This closer relationship has several advantages (e.g., tailored credit terms, greater nimbleness, easier monitoring of borrower performance, and easier renegotiation of credit terms during periods of stress).

Table 1: Recent Credit Events Erode Investors’ Confidence

Chart 1: Tightest High Yield Spreads in 40 Years	Chart 2: SME Lenders Underperforming
Chart 3: Private Leverage Is Falling	Chart 4: Bankruptcies in Line With Expansions
Chart 5: Record Corporate Profits	Chart 6: Greater Private Credit Share

The financial picture with SMEs and households is more mixed.

SMEs and Low-income Households Struggling

As mentioned above, BDC stocks have underperformed the broader equity indices. This is likely to reflect that BDC lend at floating rates and therefore tend to do less well when interest rates are falling but also that their borrowers, mainly SMEs, are not doing as well as large businesses. This is confirmed by banks and survey data.

Since the pandemic, small banks (i.e. with assets below $16bn) have seen more of an increase in delinquencies on business loans than large banks (Chart 7). Small banks represent only about 15% of total banking assets but lend mainly to SMEs, by contrast to large banks that tend to lend to bigger borrowers. Small banks’ rising business loan delinquencies therefore suggest some stress with smaller borrowers.

The small businesses survey paints a similar picture. Sales and profits have been improving though they remain below pre-pandemic. By contrast employment and capex remain depressed (Chart 8). Furthermore, despite the improvement in sales, the share of respondents who list poor sales as their single most important issue has been rising. In addition, in line with the US tariffs increase, the share of respondents listing taxes as their single most important issue has also been rising (Chart 9). Finally, there is ample anecdotal evidence that small businesses are struggling.

Low-income households are similarly struggling. The US is going through a K-shaped recovery, where the top income quintile households are doing very well but other quintiles are facing slowing or even falling real income growth. This can be seen in high delinquency rates on credit cards or auto loans (Chart 10). Lower income households have been using credit cards to pay for necessities and, due to high car prices, are struggling to remain current on their loans. In addition, the end of the student debt forbearance programs has seen a sharp increase in delinquencies.

Chart 7: Rising SME Delinquencies	Chart 8: Small Businesses. Weak Recovery
Chart 9: Small Businesses Are Struggling	Chart 10: High HH Delinquency Rates

Despite these issues, banks generally remain in good shape.

Banks Are in Good Shape

In its April financial stability report, the Fed described banks as ‘holding historically high levels of regulatory capital.’ Furthermore, banks’ profitability has kept improving, thanks to ‘healthy net interest margins.’ In addition, credit quality remains sound. The funding issues that led to the bank failures of 2023 have been resolved, for now. In fact, the Fed has just proposed a significant relaxation of regulatory capital requirements for large banks.

That said, banks, especially large banks, have been struggling to expand their loan books. Large banks’ loan-to-deposit ratios remain well below pre-pandemic (i.e. large banks have added more to their security holdings than to their lending, Chart 11). In addition, large bank lending has been falling relative to GDP (Chart 12). Small banks’ lending by contrast remains above pre-pandemic. These differences could reflect the greater regulatory burden placed on large banks, which the Trump administration intends to alleviate.

These difficulties in expanding lending could explain why banks have been relaxing credit standards. Credit standards were tightened in the aftermath of the 2023 bank failures and subsequently relaxed (Charts 13). Competition between lenders, including private credit was another factor driving the loosening of credit standards.

The risk is that going forward credit standards could get tighter. While on average private sector balance sheets are strong, pockets of weakness, e.g. loans to low-income households or to SMEs, are likely to persist. This suggests more adverse credit events that, even if they remain limited, could get lenders to tighten credit conditions.

That said, as mentioned above, the private sector is deleveraging (Chart 3). This can also be seen in the latest Fed SLOOS that shows decreased demand for business loans (Chart 14). This implies that tighter credit conditions would only have a limited impact on growth.

Chart 11: Falling Loans to Deposit Ratios	Chart 12: Falling Bank Lending
Chart 13: Tighter Credit Standards Are a Risk	Chart 14: Weaker Business Loan Demand

Market Consequences

At this stage data does not suggest the ongoing credit weaknesses will have a significant impact on growth and inflation. I therefore do not change my view on the Fed and continue to expect two more cuts in 2025, in line with markets, and three in 2026 compared with markets 2.5.

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