Fed survey shows a notable decline in loan demand

Further evidence of tightening lending conditions and a potential credit crunch can be seen in the notable decline in demand for credit by large and middle market firms in a new survey of loan officers from the Federal Reserve.

This decline will affect the real economy in the near term as investment, hiring and growth slow on the back of tighter lending.

Roughly 56% of loan officers noted a decline in demand for loans by large and middle market firms, while 53% reported a decline in credit demand by small firms, according to the Fed’s most recent quarterly Senior Loan Officer Opinion Survey released in May.

Just over 45% of lending officers reported reducing the maximum size of credit lines to large and middle market firms, while nearly 63% reported they had raised premiums for lending.

Tighter loan covenants and increased collateral requirements will be a feature of lending to large and midsize firms, according to the survey. Those requirements all jumped noticeably for smaller firms, which will pull back on economic expansion immediately based on the data in the survey. 

Approximately 46% of loan officers reported a tightening of lending standards for commercial and industrial loans for large and middle market firms, while 47% reported the same for smaller firms.

These stricter lending standards did not jump to levels observed during the pandemic. But they have been increasing for the past year, and the large decline in demand for credit among firms of all sizes indicates that the Fed’s efforts to cool the economy are bearing fruit.

Perhaps more problematic for local and regional banks—which make 70% of commercial real estate loans—was the tightening in that ecosystem.

While banks have been raising lending standards for the past year, the jump in those reporting a tougher environment denotes an increase in the risk of a hard landing for the economy. Rising interest rates are dampening overall activity as the Fed attempts to restore price stability.

Nearly three-quarters, or 73.8%, of respondents reported tougher standards for construction and land development loans, 66.7% for nonfarm nonresidential structures and 64.5% for multifamily residential structures.

Not surprisingly, loan officers noted a 67.2%, 73.8% and 72.6% decline in demand for loans across those respective sectors. 

Economic implications

Recent turmoil among local and regional banks has triggered a crisis of confidence among investors.

Increased regulatory oversight, falling equity valuations and compressed net interest margins all will most likely cause banks to pull back further on lending.

The primary implications of the Fed’s lending survey are that the cost of capital is increasing, which in turn will dampen investment, hiring and growth.

Such moves in lending tend to show up 90 to 180 days following the imposition of restrictive credit conditions. Since the tightening started in March 2023, we should observe an impact in the real economy this summer, beyond anecdotal data discussions that RSM is already having with our clients and bankers.

The Fed’s survey shows a continued reluctance to borrow or to lend in the first quarter.

In addition to the turmoil in the banking sector, the shift in monetary policy that raised the cost of overnight lending from 0.25% to 5.25% in only 14 months has contributed to this reluctance. The downturn in borrowing and lending also signals the probability of an economic slowdown as business and residential investment declines and consumers pull back on spending. 

The takeaway

The risk of a pullback in lending is rising. Reduced demand for loans and tightening credit standards will cause growth to slow as firms face rising costs of capital that supports productivity-enhancing investment and hiring.

Recent turmoil in the banking sector and a looming debt ceiling crisis are the primary reasons why we have lifted our estimation of the probability of a recession to 75% over the next 12 months.

The Fed’s survey data supports that forecast and denotes rising risk around the economic outlook linked to tightening financial conditions.

If lending conditions continue to tighten along the lines implied by this survey, the economy would do well to generate 1% growth in the second half of the year.