MFN - Tight lending standards cloud the growth outlook

Tight financial conditions are needed to restore price stability but constrain growth. Many commentators note that the recent bond and equity market rallies have eased financial conditions. However, central banks focus also on bank lending conditions as it is a critical source of financing, particularly in the eurozone. In this Macro Flash Note, GianLuigi Mandruzzato looks at loan officers' surveys and concludes that financial conditions have continued to tighten significantly.

Central banks have been aggressively raising interest rates to return inflation to levels compatible with price stability.

Many commentators associate tight financial conditions with rising bond yields and falling stock prices. They thus note that recent market rallies have partially offset the efforts of central banks and may force them to raise interest rates further, and for a longer period of time, than previously envisaged.

However, central banks assess financial conditions in broad terms, including the state of bank lending, a critical source of financing for households and non-financial corporates. To help monitor this, central banks survey senior loan officers at commercial banks.¹

In the first quarter of 2023 commercial banks tightened lending standards significantly, continuing the trend started in 2022 (see Chart 1). In the US the intensity of the restriction was greater than in previous quarters. In the eurozone, despite a slight moderation, the rate of tightening of credit access conditions was higher, for the second consecutive quarter, than the peaks reached after the outbreak of the pandemic and during the European debt crisis.

Source: Refinitiv and EFGAM calculations.

The tightening of lending standards encompasses higher interest rates, smaller loans approved than requested, and the demand for more collateral. These changes reflect both higher monetary policy rates, which raise commercial banks’ cost of financing, as well as banks’ concerns of rising non-performing loans due to the worsened economic outlook.

The mirror image of tightening lending standards is a collapse in loan demand, reported to be as intense as in the aftermath of the default of Lehman in September 2008 (see Chart 2). This bodes ill for GDP growth in the coming quarters, particularly in the eurozone where bank lending represents a larger share of private sector financing than in the US. Furthermore, the European Central Bank has signalled that it intends to continue to increase interest rates decisively to curb inflation while the Federal Reserve is seen to be close to ending its monetary policy tightening.

Source: Refinitiv and EFGAM calculations. 

To conclude, the senior loan officers' surveys in the US and the eurozone show that in early 2023 commercial banks in developed economies have further tightened lending standards. This shows how the central banks’ actions are causing a significant tightening of financial conditions for the private sector despite the recent market rally. Unsurprisingly, households and non-financial corporates have strongly reduced their demand for loans. The resulting slowdown in fixed investment and house purchases will help ease inflation in the quarters ahead.

¹ Every quarter, central banks in major Western countries ask commercial bank loan officers how the conditions applied to private sector loans have changed, how the demand for loans has changed, and which factors have had the greatest impact on these dynamics. This note refers to US and eurozone survey findings, but these are similar to findings in the UK and Japan surveys.

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