Strong bank lending is likely a big reason the Federal Reserve has been slow to slice interest rates this year, even when economic signs seems to dictate otherwise.
But some observers are starting to wonder if banks can keep dishing out such cornucopian doses of credit indefinitely, and whether liquidity problems might be ahead.
The curious pattern of bank lending over the past cycle of the economy is a factor in the current situation.
From 1989 to 1993, the Fed pursued an easy monetary policy, reducing the federal funds target rate to 3% from 9% to jump-start the economy out of recession.
It got little help from banks, which were wallowing in credit problems and in no mood to lend. Instead, bankers loaded up on Treasury securities as rates fell and focused on repairing balance sheets.
By early 1994, with banks finally lending again, the Fed commenced raising rates to brake the economy. But instead of slackening with the rising price of credit, bank lending has gained momentum.
"Despite the reduction in bank reserves brought about by the Fed's successive tightening, banks remained able to respond to loan demand by liquidating their vast holdings of securities," pointed out Andree-Anne Desmedt, director of financial services at WEFA Group, a Philadelphia-based economic consulting firm.
The economist said these recent episodes "cast doubt on the Fed's effectiveness in using credit supply as a means of achieving its monetary policy goals." Indeed, the Fed had to raise rates more than many economists had predicted to slow the economy.
Analysts see a related problem in the banking industry. As the Fed tightened significantly, banks profited handsomely by lending at higher rates while simultaneously declining to pay higher rates on deposits.
Unsurprisingly, many bank customers reacted by seeking better returns elsewhere, including in the stock market via fast-growing mutual funds.
"What's different this time around is that core deposit growth is stagnant, compounding the usual cyclical stresses," said Charles N. Cranmer, director of equity research at M.A. Schapiro & Co., New York.
"Worse, the outflow from low-cost deposit categories into higher- yielding certificates of deposit and mutual funds has raised banks' average cost of funds," he said in a new report. As a result, banks face a funding gap.
Mr. Cranmer was emphatic that "it is far too early to declare that any sort of liquidity crisis is imminent." Instead, he labeled the situation a "liquidity challenge."
In fact, banks' liquidity "is running off rapidly," he said. "Evidence points to the most serious liquidity erosion in nearly two decades."
During 1994, banks' total loans jumped from 83% to 92% of their core deposits, and deterioration at a similar rate occurred in the first half of this year.
Mr. Cranmer said the measure has shifted so sharply only once before, "in 1981, when inflation was rampant and banks were giving money away in Latin America, Texas, and the Farm Belt."
Repairing the liquidity ratio in the current relatively benign operating environment would cost banks "perhaps 2% to 4% of current earnings," he said. In a more difficult scenario, the costs will go higher.
"In our view," he said, "it is the better managements who are spending the money now to ensure a strong funding base in the future."
