Only time will cure credit ills

fedgazette Editorial

John H. Boyd
Martha L. Starr | Research Editor/Writer

Published July 1, 1992  | July 1992 issue

"They also serve who only stand and wait." —John Milton

The credit crunch is a term we see everywhere in the press, but what is being crunched seems to be mostly a function of who you are. Business owners gripe that loans are not available to creditworthy borrowers. Bankers complain that qualified loan applicants are not streaming in their doors. Policymakers worry that credit conditions prolonged the recession.

Who's right? In a sense, they all are. Yet little can or should be done at the policy level to cure our current credit ills. Most of what we have been observing in the credit markets is quite normal and predictable for a recessionary period. Indeed, some observers would go beyond predictable. They would characterize a credit contraction as healthy for the economy. Of course, that may be true only if you can take the long view. Hence borrowers and bankers can both be right in their complaints, but policymakers would still help most by doing nothing.

Despite their general similarities, no two recessions are exactly alike. Each has its own unique factors, and this recession has been no exception. The factors unique to this recession have worsened credit conditions, but relieving them would exact too high a social toll. Most of us are all too familiar with the demise of the savings and loan (S&L) industry, and the For Rent signs peppering our city office buildings, shopping malls and apartment buildings are equally hard to miss. A third factor, and one that may be less well known, is the adverse effect new bank capital regulations have had on credit availability in areas of the country like New England. These three phenomena are unique to this recession, but only time, not intervention, will provide the best cure. Little can be done at a policy level except to pursue normal macroeconomic policies and to wait for the economy to recover—something that it appears to be doing, anyway.

A normal credit condition ...

Despite the many media stories to the contrary, what we are observing now is not really a credit crunch in the historical sense. Historically, the term refers to disintermediation out of banks, a state in which extremely high open market interest rates lure away large numbers of bank depositors. Clearly, that's not what's happening today. Open market interest rates are low by recent standards, and Regulation Q—an interest-ceiling culprit in previous recessions—is also defunct.

What is supported by the data is the perception that banks and S&Ls are lending less. Over the full year 1991, bank holdings of commercial and industrial loans fell about 10 percent while banks' consumer loans decreased about 9 percent over the same interval, commercial banks bond holdings rose around 18 percent. (This combination is particularly annoying to borrowers whose applications are refused while their bank is buying government bonds.) In 1991, S&L holdings of mortgages and mortgage-backed securities plummeted by around 14 percent.

What is missing from most popular press analyses of these data, however, is that this behavior is quite normal during recessions. "In recessions and periods of slow economic growth, when loan demand and interest rates tend to be lower, banks usually have relatively large amounts of funds to invest in securities," write the authors of a widely used text, Bank Management: Text and Cases. "In the ensuing boom period, when loan demand and interest rates tend to be high, the bank is usually unable to purchase securities and may be forced to sell previously purchased securities at losses in order to finance loan growth." Although this passage was written a number of years ago, it accurately describes today's conditions.

If we want to see what's really going on in the credit markets today, we have to look at both the supply of credit and the demand for it. But during this recession, most of the media attention has been focused on the supply of credit. The newspapers tell us of solid business owners who apparently can't get loans. This gives readers the impression that the demand for loans is high and that fearful and over-regulated bankers prolonged the recession by refusing to lend. And the loan data mentioned earlier would seem to support this.

But what about demand for loans? Demand forces have been at work during this recession, just as they were in all previous ones. Corporate demand for credit normally falls in any recession because demand for those corporations' goods and services falls as well. Businesses simply need less funding for inventories, accounts receivable or capital investment during recessions, thus providing another explanation for the drop in loan volume. This has certainly been true in this recession, and businesses aren't the only ones with reduced credit needs. Consumer demand for credit also normally declines in recessions. Many individuals are less certain about their income, and some, unfortunately, have become unemployed. Not surprisingly, they then become cautious when it comes to borrowing. Further, rising unemployment results in weaker demand for goods, which feeds back to lower corporate demand for investment and working capital.

Even with overall demand reduced, most businesses still need to borrow, and those that do usually find lenders more cautious during a recession than they were during boom times. Often, a bank's capital position is weaker during a recession because of losses from bad loans. Bank examiners and supervisors observe this weakened condition and then exhort bankers to be careful and to rebuild their equity capital. This is certainly true now. Indeed, the conflict between policymakers and examiners over lending standards has been characteristic of this recession. Examiners have been strongly criticized in the press, but it's their job to minimize bank failures, with their attendant social costs, and to maintain the integrity of the deposit insurance funds. Nor does it seem particularly helpful for policymakers to tell bankers, as they did in 1991, "to make good loans." This makes about as much sense as ordering ducks to swim: If the opportunities exist, either group will do what comes naturally.

Some economists who have studied this phenomenon say it's not only normal but actually healthy for credit to contract during a recession. Edward Green and Soo Nam Oh, the authors of a recent article in the Minneapolis Fed's Quarterly Review, argue that bankers provide a welfare-enhancing service during recessions by restricting loans to some of those who are creditworthy in order to help those borrowers who have fallen on hard times.

So the long view of credit conditions is that both the demand for and the supply of credit contract during recessions and that this phenomenon is quite natural and normal.

... With unique ills ...

Along with the normal contraction of credit, this recession has also had its share of unique aspects. Three factors unique to this recession have made credit conditions even more difficult, at least in terms of recent economic experience.

On the demand side, we entered this recession with an enormous oversupply of commercial real estate in most of the United States. In many cities, office vacancy rates are still running near 20 percent or more, the highest rates in many years. Apartment buildings and shopping malls are also widely overbuilt. As a result, demand for new commercial construction is abnormally low, and it will remain that way even as the economy moves into recovery.

Another factor that has adversely affected the supply of credit has been the dismantling of the savings and loan industry. Beginning around 1989, the federal deposit insurers began in earnest to liquidate many bankrupt S&Ls. This means that a large number of lenders, especially in commercial real estate, have been removed from the market. Inevitably, this must have an adverse effect on the supply of credit, at least until new lenders enter these markets and begin to offset the S&L exodus.

Partially as a result of the S&L disaster, new standards for bank capital have been established that will become fully effective in 1993. The so-called Bank for International Settlement (BIS) standards were adopted in Basel, Switzerland, and they apply to banks in a number of industrialized countries as well as the United States. Recent research by Joe Peek and Eric Rosengren at the Boston Fed shows that these new capital regulations are impeding bank lending in the New England area. The effect of new capital requirements is likely felt more adversely in that area of the country, in part because the recession itself has been more severe there. For those banks with substantial numbers of problem loans, these new regulations are a binding constraint that adversely affects the pace of recovery for the New England area.

... And a normal cure

So what's to be done about these three factors? In our view, the best prescription is nothing. The overbuilding of commercial real estate is a reality. The structures are there, and short of blowing them up, the only option is to wait until demand catches up with supply. Only time will cure this ill.

Some observers have advocated government subsidies to commercial real estate to stimulate demand for existing structures as well as create demand for new ones. The problem with this idea is that, to a large extent, such moves were what got us into this mess in the first place.

Greater agreement exists when it comes to the notion of resuscitating the S&L industry. No one is advocating a policy of trying to restore that industry's former vigor. The S&L debacle will end up costing the taxpayers in excess of $200 billion, and no one is eager to ante up again for an industry that is largely on life support. The healthy S&Ls, and it's worth noting that they exist, can take care of themselves. But like the many vacant office complexes around the country, the bankrupt S&Ls waiting in line to be closed are facts that cannot be changed. Only time will cure this ill.

For much the same reasons, relaxation of the bank capital standards would be an enormous mistake. Following in the footsteps of the S&Ls' Federal Saving and Loan Insurance Corporation (FSLIC), the Federal Deposit Insurance Corporation (FDIC) has just gotten a huge new infusion of capital. Many question whether the banking industry will ever be able to pay that bill without putting the bite on taxpayers. Relaxing capital standards would once again put taxpayers in position to reach for their wallets if another round of loans go bad.

What's more, the United States was a leader in the long and difficult process of reaching agreement on the new BIS capital standards. Backing away from the terms of this agreement before it's even fully implemented would send a bad signal to other countries and would undermine the United States' credibility in future international financial negotiations.

The BIS standards are an attempt to get all competitors, regardless of their country of origin, on a level playing field. In the long run, these new standards will prove valuable to banks here and abroad. Yet for New England and other hard hit areas, only time will cure this ill.

As we see it, no quick cure is possible. No magic remedy exists to whisk away our current credit ills, at least none in which the benefits exceed the costs. Thus the sensible course of action is inaction. We must simply wait for the economy to recover, as it appears to be doing. Given time, the oversupply of commercial real estate will be absorbed naturally; bankrupt S&Ls will be liquidated in an orderly manner; and banks will be meeting the new BIS capital standards more and more easily as the economic recovery progresses.