Lending standards are essential to the stability of the overall economy in the dynamic world of finance.
One important source of funding for businesses and households is banks.
In recent times, there has been a discernible change recently as banks tighten lending requirements. Banks are growing more tight-fisted with loans to businesses and individuals.
This article examines the causes of this shift, the effects it will have on borrowers and businesses, and its wider implication for the economy.
What does tightening lending mean?
“Tightening lending” is the term used to describe the practice of banks and other financial organizations making it harder for borrowers to get credit or loans.
This is accomplished by enforcing more stringent lending requirements and elevating the benchmarks that applicants must fulfill in order to secure funding.
This could mean:
- stricter documentation requirements
- more stringent documentation requirements
- higher interest rates
- fewer lending possibilities
It becomes more difficult for borrowers to obtain loans or credit lines when lending criteria are tightened, since they must go through a more stringent and selective approval process.
Are banks tightening their lending?
The Federal Reserve asked banks in a report whether they have tightened lending standards by, among other things, requiring higher credit scores, charging higher interest rates, or requiring more collateral, all of which would make it more difficult for businesses and consumers to obtain loans.
The report, known as the senior loan officers survey, revealed that banks have raised their lending standards for business and consumer loans in the wake of three large bank failures and plan to raise them further this year, a trend that could slow the economy in the coming months and increase the likelihood of a recession.
Approximately 46% of all banks reported that they had raised requirements for commercial and industrial loans, up from just under 45% in the previous quarter.
Why are banks tightening their lending?
There are various reasons why banks tighten lending standards to individuals and small businesses. Lets have a look at them.
#1. Economic conditions
During economic downturns, banks become more risk-averse and hesitant to lend in order to secure their assets and minimize potential losses.
The present economic condition which has been mired with inflation, financial crises and the looming possibility of a recession, has led to tighter lending standards from banks.
#2. Monetary policy
Because banks must modify their capital and liquidity requirements to account for shifts in monetary policy, central banks’ monetary policies have an effect on the availability of loans.
For instance, banks typically raise their reserves at a time of high interest rates, since borrowing costs are high but so is the danger of defaulting.
#3. Asset quality concerns
Short-term rates have an impact on borrowers’ creditworthiness and, consequently, the cost of loan.
Since banks closely monitor the quality of their loan portfolios, a decline in the quality of assets, such as a higher percentage of non-performing loans, might result in tighter lending requirements to stop future losses.
#4. Credit risk concerns
Credit risk is always being evaluated and managed by lenders, especially in difficult economic times. Lenders may tighten lending conditions in response to an increase in delinquencies or loan defaults in order to limit their exposure to high-risk borrowers.
#5. Risk management
Periodically, lenders evaluate and modify their risk management strategies.
If they perceive an increase in risk in their lending portfolios, they might restrict their standards in order to maintain a balanced risk profile.
#6. Bank turmoil
The recent bank turmoil which led to the collapse of three regional US banks and the demise of Credit Suisse which subsequently led to its acquisition of UBS has pushed banks to tighten their lending conditions.
According to the Federal Reserve report, more lenders tightened their lending requirements following the turmoil that rocked the banking industry earlier in the year.
What will happen if the banks don’t lend?
When banks tighten lending standards, this tends to have implications for individuals, businesses, and the economy.
Here are some of the scenarios that could play out when banks reduce access to loans.
Increased down payment requirements
Banks may demand higher down payments for mortgages, which lowers the loan-to-value (LTV) ratio. This implies that in order to buy a property, borrowers need more cash up front.
Lack of capital for businesses
Capital is necessary for businesses to be able to fund their activities.
There is a reduction in firm capital when banks tighten lending requirements. As such, a business would only engage in a certain number of undertakings and endeavors. For instance, the lack of funding would force the company to postpone its plans for expansion.
Businesses would close down
When banks tighten lending conditions, this means businesses would not be able to borrow money due to tougher conditions.
The inability to get funds from banks would not only affect operations but may also force them to close shop, especially if the business is small.
Increased unemployment
Lack of access to credit means that businesses would hire fewer people as they have to manage costs. To survive, businesses may have to lay off people or ultimately shut down. This would increase unemployment levels in the economy as there would be fewer jobs.
Less consumer spending
Reduced access to credit can impact consumer spending, as individuals have less available credit to finance purchases. This can affect industries dependent on consumer spending.
Less demand for homes
Stricter financing requirements may have an impact on the housing market. Mortgage eligibility may decline, which might reduce demand for properties and cause price stagnation.
Possible recession
A business shutdown increases unemployment, which would ultimately plunge the economy into a recession because there are fewer people working. Hence, less money circulating in the economy to keep it afloat.
Do banks still give loans?
Banks still give loans, but the conditions are tighter and the borrowing costs are higher. On the flip side, there is also less demand for loans now compared to 2020.
According to the Fed survey mentioned earlier, out of the 405 enterprises surveyed, 60% said they were not looking for financing because they had enough cash on hand to fund their anticipated activity for the upcoming year.
A further third of the companies said they did not want to take on more debt, and 16% of those who said they would not be looking for credit financing in the upcoming year said the interest rates were too high for them to think about getting more credit.
Banks Tighten Lending: Final Thoughts
It’s crucial to remember that the effects of stricter lending standards might differ depending on:
- the state of the economy as a whole
- the regulatory landscape
- the lending policies of particular banks and lenders
Stricter regulations may impede economic development and loan availability for some borrowers, even while their primary goal is to lower risk and preserve financial stability.
However, starving firms and households of loans can lead to an economic downturn, because the purchasing power of consumers is lower and the borrowing and operating costs of businesses are high. This can push the economy into a recession.
As a borrower, you need to be ready to adjust and look into other options for funding your goals and endeavors when banks react to changes in the economy and regulations.
