Banks Warn Fed Inverted Yield Curve Would Tighten Lending Conditions

Today the Fed released the Q3 edition of the Federal Reserve's Senior Loan Officer Opinion Survey (SLOOS), which confirmed that lending standards remained accommodative irrespective of the flatter UST yield curve, and reported a modest easing in lending standards and terms for C&I loans, but also weaker demand for those loans. Banks also reported weaker demand for both commercial and residential real estate loans, echoing the softer housing data in recent months.

The details:

  • The net percentage of banks reporting easier standards on loans to large- and medium-sized firms stayed flat at 16%, while standards for small firms were basically unchanged on net.
  • Terms on C&I loans eased somewhat for large- and medium-sized firms, as 27% of banks surveyed (in net terms) reportedly narrowed spreads of loan rates over the cost of funds; other terms, such as premiums charged for riskier loans, loan covenants, and collateralization requirements, all eased somewhat.

Despite the easier conditions, however, demand for C&I loans weakened somewhat, with "somewhat weaker" demand reported from both large and small firms. The net percentage of banks reporting decreased new business loan inquiries was 15%.

At the same time, demand for CRE loans across a broad range of categories reportedly also weakened even as lending standards on CRE loans were largely unchanged.

The same pattern was observed for residential mortgage loans, where banks reported that lending standards also eased on net in Q3 across most residential loan categories, even as demand was moderately weaker across all surveyed residential loan categories, including home equity lines of credit.

One place where banks saw modest tightening in lending standards in Q3 in comparison with the beginning of 2018, was in credit card and auto loan applications: banks were less likely to approve loans for borrowers with FICO scores of 620; they were more likely than in Q1 to approve such consumer loans for borrowers with FICO scores of 720.

The Fed also included several rather topical special question, asking how banks are being affected by the shape of the yield curve. Banks reported that their C&I lending standards or prices were unaffected by the flattening in the slope of the yield curve so far this year. Other special questions in the survey asked banks how their policies would change in response to a hypothetical yield curve inversion next year.

"Those banks that indicated they would tighten their lending policies because of an inversion of the yield curve were asked to provide reasons for their response.

Major shares of banks indicated that their bank would interpret this scenario as signaling a less favorable or more uncertain economic outlook and as likely being followed by a deterioration in the quality of their existing loan portfolio.

In addition, major shares of banks reported lending would become less profitable and their bank’s risk tolerance would decrease in this scenario."

In other words, the Fed's concerns about curve inversion are justified as a prolonged, moderate curve inversion would cause banks to tighten standards and price terms for C&I and commercial real estate (CRE) loans. A significant share of banks said that should the yield curve invert, they would tighten lending standards, as they would view a moderate yield curve inversion both as signaling a “less favorable or more uncertain” economic outlook and as likely to reduce the profitability of lending.

One look at the chart below showing just how flat the yield curve currently is relative to easy lending conditions, it is perhaps most surprising that bank loans aren't far more tight.

As for the banks' response, it is important because despite the occasional arguments from random FOMC members, especially those in the "this time it's different" camp, that an inverted yield curve is irrelevant, with bank officers confirming they would tighten financial conditions should the curve invert, then the Fed does need to take a curve inversion seriously. And, as Bloomberg's Ye Xie writes, "from that perspective, a curve inversion may actually be good news as it suggests that the Fed would need to pause and re-assess once the curve flips."