After a long drought, there are preliminary signs that loan demand could be picking up.
One indication: Bank holdings of Treasury securities are rising at a slower rate.
Banks have profited handsomely over the last two years by loading up on Treasury securities rather than making loans. This has been a no-lose strategy because of the unusually wide spread between funding costs and the rates banks can earn on short- to intermediate-term government securities.
But the slowdown in securities purchases suggests that banks are making more investments in loans - and that the banking industry's wild ride on the steep yield curve is winding down.
To be sure, it's far too soon to draw a firm conclusion. The evidence is largely anecdotal and much depends on whether the economy is really starting to perk up.
But some observers are beginning to express cautious optimism that loan demand is on the rise.
More Funds for Lending
Sung Won Sohn, chief economist at Norwest Corp. in Minneapolis, aid bank holdings of Treasury securities have been rising at a slower rate in recent weeks because loan demand from small to medium-size companies is picking up slightly.
"It looks like loan demand is at least bottoming and showing some signs of recovery," he said.
And though it hasn't happened yet, demand eventually will increase for bank loans to finance the buildup in inventories, said Ed Yardeni, chief economist at C.J. Lawrence.
One thing's for sure: The industry would welcome an increase in lending.
In June, bank holdings of government securities surpassed outstanding business loans for the first time in 27 years.
Catching Flak
That opened banks up to charges that they were becoming more like bond funds than lending institutions. And earlier this year, Federal Reserve Board chairman Alan Greenspan chided banks for being timid lenders.
Bankers and private economists generally blame the lending contraction on stiffer capital requirements, harsh bank examiners, a recession-induced decline in borrower creditworthiness, and - most important - a lack of loan demand.
At the same time, though, the Treasury market has probably siphoned off at least a marginal amount of bank funds that might otherwise have gone to private borrowers.
If the yield curve wasn't so steep, buying Treasuries would not have been such an attractive alternative to making riskier loans.
"Then, I think banks would have had to work a lot harder to find loan demand - and they might have found it," says Mr. Yardeni.
So far this year, the spread between the federal funds rate - a good proxy for bank funding costs - and two-year Treasury notes has averaged 120 basis points, compared with an average spread of 79 basis points in 1991, and just 6 basis points in 1990, according to Dana Johnson, head of market analysis at First National Bank of Chicago.
Curve Could Steepen
And in the short run, that spread might get wider. "I think the yield curve will actually steepen," says Mr. Johnson.
The spread between bank funding costs and two-year Treasuries could widen if the bond market becomes convinced of a credit tightening by the Fed.
That spread could approach 200 basis points, says Mr. Johnson, who noted that the spread between the federal funds rate and two-year notes was as high as 193 basis points in late April.
But any Fed tightening would be in response to a strengthening economy, which would be accompanied by increased loan demand and improved creditworthiness of borrowers. And banks probably would meet that demand.
Affect of Interest Rates
After all, the spread between the bank funding costs and the prime lending rate is 300 basis points.
Moreover, if interest rates drift upward, banks would want to lighten their holdings of Treasury securities because of the capital losses they would face.
The recent spike in interest rates has already eaten into the paper gains that banks have made this year on their securities holdings.
For now, though, it's still not clear that Fed easing has run its course.
While the nation's gross domestic product grew at a faster rate than expected in the third quarter, other data suggested that the economy is still limping along, economists note.
