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Recent Developments in Business Lendingby Commercial Banks
William F. Bassett and Egon Zakrajsˇek, of the Board’s Division of Monetary Affairs, prepared this article. Jason Grimm and Steve Piraino provided researchassistance.
After growing rapidly during much of the 1990s, theinflation-adjusted value of commercial and indus-trial (C&I) loans at domestic commercial banks andat U.S. branches and agencies of foreign bankshas fallen 19 percent since the beginning of 2001(chart 1).
1
This striking decline in aggregate C&Iloans masks important differences in lending patternsat domestically chartered institutions of differentsizes and at U.S. branches and agencies of foreignbanks. A drop in loans at large domestic commercialbanks and at foreign institutions accounts for theentire contraction in C&I loans since January 2001.
2
In contrast, the real growth rate of business loansat small commercial banks, though it has declinedappreciably, has averaged almost 4 percent annuallysince early 2001. The recent runoff in C&I loanscontrasts sharply with that of the early 1990s: Theearlier contraction in lending at large and smalldomestic banks was more uniform and was partlyoffset by a robust expansion of business loans atforeign institutions (chart 2).Although branches and agencies of foreign banksare important participants in the C&I loan market,this article focuses on business lending at domesticinstitutions, for two reasons.
3
First, U.S. branches and
1. C&I loans are business loans not secured by real estate.2. Banks consist of the following types of institutions in the fiftystates and the District of Columbia: domestically chartered commer-cial banks that submit a weekly report of condition (large domestic);other domestically chartered commercial banks (small domestic);branches and agencies of foreign banks, and Edge Act and agreementcorporations (foreign-related institutions). Banks exclude interna-tional banking facilities. The category of large domestic banks in theFederal Reserve’s weekly H.8 statistical release, ‘‘Assets and Liabili-ties of Commercial Banks in the United States,’’ includes about fortyof the largest domestic commercial banks, which together account forabout 55 percent of assets held by all domestic banks. Domesticinstitutions not included in the large bank category compose the smallbank category. Large domestic banks constitute a universe; data forsmall domestic banks and foreign-related institutions are estimatesbased on weekly samples and on quarter-end condition reports. Dataare adjusted for breaks caused by reclassifications of assets andliabilities. The data for large and small domestic banks are alsoadjusted to remove the estimated effects of mergers between thesetwo groups. For further details about the H.8 release, seewww.federalreserve.gov/releases/h8.3. For further discussion of foreign banking organizations, seeAllen N. Berger and David C. Smith, ‘‘Global Integration in theBanking Industry,’’
Federal Reserve Bulletin
, vol. 89 (November2003), pp. 451–60.
2. Real growth rate of C&I loans,by type of bank, 1988
–
2003
Smalldomesticbanks
2010+_01020
Percent
20032001199919971995199319911989 LargedomesticbanksForeign-relatedinstitutionsN
OTE
. The data are monthly through October 2003; change is for twelvemonths. See also text note 2.
1. Real value of C&I loans at banks, 1988
–
2003
6007008009001,0001,100
Billions of 1996 dollars
20032001199919971995199319911989 N
OTE
. The data are monthly through October 2003 and are deflated by theprice deflator for business-sector output (1996 = 100). Here and in thefollowing charts, shaded bars represent recessions as dated by the NationalBureau of Economic Research. See also text note 2.S
OURCE
. Federal Reserve Board, Statistical Release H.8,
“
Assets and Lia-bilities of Commercial Banks in the United States
”
(www.federalreserve.gov/releases/h8); Bureau of Economic Analysis.
 
agencies compete most directly with large domesticbanks for customers in the C&I loan market. There-fore, the factors that depressed lending at largedomestic banks over the past three years likelyexerted a similar in
fl
uence on foreign institutions.Second, the analysis of business lending at branchesand agencies of foreign banks is complicated by thepronounced downward trend in their share of C&Iloans (chart 3). The reduced intermediation by for-eign institutions since the mid-1990s has been duelargely to a sharp pullback in business lending by theU.S. branches and agencies of Japanese banks, manyof which are saddled with a substantial volume of nonperforming loans and face signi
fi
cant pressureson their capital positions.The divergence between large and small domesticcommercial banks in the growth of business loansover the past three years appears to stem from thecombined effects of weakness in demand for C&Iloans from larger businesses and a relatively greatertightening of supply conditions at large banks.Although sharp cutbacks in capital spending andsteep inventory runoffs since early 2001 have sig-ni
fi
cantly reduced demand for C&I loans from bor-rowers of all sizes, the decline in loan demand fromlarger corporate borrowers
—
which maintain lendingrelationships mainly with large banks
—
has beenespecially pronounced. The reduction in demand forbusiness loans from larger
fi
rms has been exacer-bated by an evaporation of merger and acquisition(M&A) activity and a substitution of bond
fi
nance forbank loans on
fi
rms
’
balance sheets. On the supplyside, large commercial banks tightened their creditstandards and began imposing more stringent loanterms well before the recent economic downturn.These institutions further tightened their commercialcredit policies as the economy slipped into recessionand as a substantial deterioration in the credit qualityof their borrowers pushed delinquencies and charge-offs on C&I loans to high levels.The move toward a more stringent lending postureby domestic commercial banks before and during therecent economic downturn, although partly cyclical,has also been in
fl
uenced by a reassessment of therisk 
–
return tradeoff inherent in C&I lending, espe-cially relative to the lax lending atmosphere of themid-1990s. These structural changes in the way com-mercial banks price and allocate certain forms of business credit likely represent the cumulative effectof signi
fi
cant institutional developments in the C&Iloan market since the late 1980s. In large part, thesedevelopments have arisen from the increased partici-pation of nonbank 
fi
nancial institutions in the syn-dicated loan market, which in turn has contributedimportantly to the growth of the secondary loan mar-ket and of leveraged lending
—
that is, lending tolarge below-investment-grade borrowers. To theextent that these markets are almost exclusively prov-inces of large
fi
nancial institutions, the reassessmentof the attractiveness of syndicated and some formsof traditional C&I lending has disproportionatelyaffected large commercial banks and has contributedto the divergence in business lending patternsbetween large and small domestic banks.In contrast to C&I loans, other forms of credit atdomestic commercial banks have
fl
owed relativelyfreely during the past several years. Although thegrowth of real bank credit declined notably duringthe 2001 recession, it did not fall as low as it didin the early 1990s, and its recovery has been much
3. Share of C&I loans held by U.S. branches andagencies of foreign banks, 1988
–
2003
152025
Percent
20032001199919971995199319911989 N
OTE
. The data are monthly through October 2003.S
OURCE
. Federal Reserve Board, Statistical Release H.8.
4. Change in real value of bank credit, 1988
–
2003
+_0510
Percent
20032001199919971995199319911989 N
OTE
. The data are monthly through October 2003 and are deflated by theGDP price deflator (1996 = 100); change is for twelve months.S
OURCE
. Federal Reserve Board, Statistical Release H.8.
478 Federal Reserve Bulletin December 2003
 
brisker (chart 4). In this cycle, bank credit has beenbuoyed by a substantial expansion of banks
’
realestate portfolios and holdings of mortgage-backedsecurities. At the same time, the growth of consumerspending has held up well, allowing commercialbanks to continue increasing their holdings of creditcard and other types of consumer loans. Partly as aresult of the robust lending to households, a resilientcommercial real estate loan market, and growth infee-generating lines of business, commercial bankshave remained highly pro
fi
table despite an increasein loan losses, especially on C&I loans (chart 5).Thus, in sharp contrast to the circumstances of theearly 1990s and despite some restrictions on thesupply of business credit from large domestic com-mercial banks, the banking sector has remained wellcapitalized and is poised to support growth in demandfor business loans (chart 6).
F 
 ACTORS
A
FFECTING THE 
D
 EMANDFOR
C&I L
OANS
Between 1997 and 2000, spending on capital equip-ment by businesses boomed. As a result, the gapbetween capital expenditures and internally gener-ated funds for the nonfarm non
fi
nancial corporatesector
—
relative to the output of the sector
—
shot upfrom 1
1
 ⁄ 
2
percent at the end of 1997 to more than4 percent at its peak in 2000 (chart 7). Concomitantly,the bull market in equities supported a frenzied paceof mergers and acquisitions, for many of which com-mercial banks provided initial
fi
nancing. Not surpris-ingly, the expansion of C&I loans at both large andsmall domestic commercial banks reached double-digit annual rates over this period.The strong pace of corporate spending, how-ever, proved unsustainable, and companies sharplyreduced their capital expenditures as the economy
entered recession in March 2001. Firms also responded
quickly to falling sales by curtailing production to
6. Regulatory capital ratios, 1990
–
2003:Q3
Leverage ratio
68101214
Percent
2003200119991997199519931991 Tier 1 ratioTotal (tier 1 + tier 2) ratioN
OTE
. Regulatory capital ratios are seasonally adjusted. Tier 1 capitalconsists primarily of common equity (excluding intangible assets such asgoodwill and net unrealized gains on investment account securities classifiedas available for sale) and certain perpetual preferred stock. Tier 2 capitalconsists primarily of subordinated debt, preferred stock not included in tier 1capital, and loan
–
loss reserves. Total capital is tier 1 plus tier 2 capital.Risk-weighted assets are calculated by multiplying the amount of assets andthe credit-equivalent amount of off-balance-sheet items (an estimate of thepotential credit exposure posed by the item) by the risk weight for eachcategory. The risk weights rise from 0 to 1 as the credit risk of the assetsincreases. The leverage ratio is the ratio of tier 1 capital to average tangibleassets. Tangible assets are equal to total assets less assets excluded fromcommon equity in the calculation of tier 1 capital.S
OURCE
. Call Report.
Return on equity+_0246810121416
5. Measures of bank profitability, 1985
–
2003:Q3
Percent
+_0.2.4.6.81.01.21.4
Percent
Return on assetsN
OTE
. The return on equity and the return on assets are annual; for 2003,they are estimates based on seasonally adjusted data through 2003:Q3.S
OURCE
. Call Report.2003200019971994199119881985
7. Financing gap at nonfarm nonfinancialcorporations, 1988
–
2003:Q2
+_01234
Percent
20032001199919971995199319911989 N
OTE
. The data are annual through 2002; for 2003, they are estimatesbased on data through 2003:Q2. The financing gap is the difference betweencapital expenditures and internally generated funds, expressed as a fraction of output by the nonfarm nonfinancial corporate sector.S
OURCE
. Federal Reserve Board, Statistical Release Z.1,
“
Flow of FundsAccounts of the United States,
”
table L.101 (www.federalreserve.gov/ releases/z1).
 Recent Developments in Business Lending by Commercial Banks
479
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