2Q Trends in Bank Lending

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JANNEY MONTGOMERY SCOTT www.janney.com

ECONOMICS • PAGE 1

CONTENTS

INTRODUCTION FED & BANK LENDING 2Q BANK LENDING NUMBERS CONCLUSIONS

INFORMATION & DISCLAIMERS

See page 3 for important information regarding certifications, our ratings system as well as other disclaimers.

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Chief Fixed Income Strategist 215 665 6034

[email protected]

Bank lending appears to have stabilized at a lower

growth rate post-recession, though competition

for C&I lending is causing terms to deteriorate.

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ntroductIon

• Growth in bank lending has been sluggish throughout most of the post-recession period, largely as a function of consumers and businesses not demanding credit; that’s one disappointing as-pect of QE transmission.

• Recent readings suggest lending is accelerating in certain categories—most notably C&I—but the impact on overall loan growth is not all that substantial.

• Loan growth is substantially higher at larger institutions, which is a signal of greater competi-tion, market share grab, and possibly a divergence in borrowing demand between smaller and larger borrowers.

• Any credit cycle downturn is still some years away, but the relaxation of lending standards in both C&I and auto lending should be a source of concern, both economically and depository balance-sheet-wise.

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Although the topic has faded from economic attention in recent quarter, bank lending remains a crucial component of the domestic economy. As we’re fond of saying, the greater and greater ability of consumers to borrow in the thirty years leading up to the Global Financial Crisis accounted for nearly a third of all economic growth. The consumer (and business, though to a lesser degree) shock and hangover that the 2008 – 2009 crisis generated has drastically altered demand for credit, both in the US and around the globe. One of the great ironies of bank critics during the early recovery days was that a lack of borrower demand was far more powerful an obstacle to credit expansion than was bank unwillingness to lend.

-4% -2% 0% 2% 4% 6% 8% 10% 12%

Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 All Loans Resi. Mtge

C&I Auto

Loan growth averaged 2.5% per quarter for five years prior to the great recession vs. 1.4% since

Qrtly Loan Growth Has Been Generally Sluggish Since End of the Great Recession

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For 2Q, loan growth at big banks exceeded that at midsize and smaller banks, largely on a divergence in C&I lending.

This lack of borrower demand represented a big problem for the latter Fed’s QE programs. Although the first QE was designed to shore up financial system liquidity, the second and third were designed to stimulate some inflation and economic growth. One—though certainly not the only—channel for Fed policy to be transmitted to the real economy was via increased bank lending. With the Fed providing cash to banks and driving the yield on securities lower, banks were more likely to lend. Though the theory was sound in a vacuum, the real world lack of demand for credit restricted mon-etary policy transmission through bank lending.

For policymakers, QE rounds two and three were about avoiding deflation and encouraging growth, but among critics, the aggressive bond buying programs sparked fears of inflation run amok. At this stage, nearly two years after the launch of the final QE program, it’s safe to say that inflation is nei-ther amok nor is it running. Despite the creation of nearly $4 trillion of money, inflation expectations a quite firmly anchored, with the TIPS breakevens projecting very reasonable +2.2% rise in the CPI for the next decade. Once again, the lack of bank lending plays a major role here. Monetary infla-tion occurs when more money chases fewer goods and services. QE took bonds out of the hands of banks, but these bonds were replaced largely by cash, not by loans. Had consumers and business been interested in borrowing, more of this QE would have found its way into the purchase of goods and services, QE would have been more inflationary. It stands to reason then, that bank lending could have an inflationary impact.

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Banks >$100bln (56% of US Bank Loans)*

Date _LoansAll _MtgeResi. CRE C&I Auto Card

Jun-14 1.5% -0.1% 0.2% 3.6% 2.4% 2.1% Mar-14 0.3% -1.3% 0.0% 2.6% 1.6% -5.3% Dec-13 2.3% -0.8% 2.8% 4.4% 1.4% 4.0% Sep-13 1.3% -1.7% 0.7% 1.5% 3.3% 0.0%

Banks $1-10bln (8% of US Bank Loans)*

Date _LoansAll _MtgeResi. CRE C&I Auto Card**

Jun-14 -0.7% 0.5% -1.4% -3.1% 2.4% 5.5% Mar-14 1.9% -0.6% 3.3% 3.3% -1.7% -3.6% Dec-13 1.1% -1.3% 0.7% 5.9% 1.0% 8.2% Sep-13 5.1% 3.9% 3.7% 3.5% 5.1% 4.9%

All Credit Unions (8% of US Bank Loans)

Date _LoansAll _MtgeResi. Other _RE Auto Card

Jun-14 NA NA NA NA NA Mar-14 1.2% 1.8% -1.7% 2.5% -2.5% Dec-13 2.2% 2.1% 0.3% 2.4% 4.6% Sep-13 2.9% 3.3% -0.4% 3.4% 2.8%

*Adjusted for changes in composition of group over time. **Small base and subject to sometimes large fluctations.

Loan Growth Details By Category & Institution Size

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Lending terms have dete -riorated more for C&I loans than for other categories.

Although the first several years of “recovery” experienced anemic consumer and business credit demand, there have been glimmers of improving bank lending volumes. From recently-released 2Q balance sheet data, loan growth measured +1.9% quarter-over-quarter, the fifth consecutive quar-terly increase. On an annual basis, that translated into a +5.7% overall loan growth, which is well in excess of the roughly +2.0% CPI inflation rate. There are, however, numerous “buts” in the loan growth story, as the expansion is quite concentrated (our notable conclusions are below the tables).

• The first level of concentration is by lender size. Banks >$100 billion in assets, a select group of institutions which cover 58% of loans, saw loan growth of +1.5% QoQ in 2Q, while banks in the $1 – 10 billion range faced contraction of -0.7%.

• The second level of concentration is by lending category. Nationwide C&I loans expanded +3.4% QoQ, while auto loans expanded +3.0%, while other categories such as commercial real estate and mortgage lending were each up less than 1%.

• Combining these two concentrations reveals a +3.4% QoQ expansion in C&I lending among banks >$100 billion versus -3.1% for banks $1-10 billion, though auto lending was even across large and mid-size institutions.

• There have been “false starts” in loan growth trends before, most notably the five quarters of growth ending in 4Q 2011 in which lending balance expanded by 11.9% YoY (largely the result of mortgage reboot). It’ll take a few more quarters of data to prove whether the current lending expansion is such a false start, as was the case in 2011.

• Credit union data for 2Q isn’t available by-and-large, but recent loan growth experience among CUs has been slower and more stable than among banks. Auto lending appears to be a less-prominent portion of recent growth.

The implications of lending concentration, however, are quite significant. First, it appears that larger banks are getting more aggressive in pricing. Perhaps the most obvious data comes from the Federal Reserve’s Survey of Terms of Business Lending. The below table summarizes the changes between the May 2014 and the May 2013 survey, but the upshot is that Fed-defined “large banks” were cut-ting their lending terms, whereas “small banks” were holding terms steady. These looser terms go a long way to explaining the trend of sizable C&I growth at the largest US banks. We’ve heard a fair shake of anecdotal reports of more aggressive C&I loan pricing and borrower-friendly terms from the regional and national banks, and the Fed’s data appear to bear out those stories.

All Banks, All C&I Loans May-14 May-13 Change

% of Loans to Moderate Credits 44% 35% 9%

% Loans to Minimal/Low Credits 23% 27% -5%

WAM on Moderate Risk Loans 34 mths 27 mths 6 mths

% Moderate Risk Loans Collateralized 31% 48% -17%

Domestic Big Banks May-14 May-13 Change

% of Loans to Moderate Credits 56% 52% 4%

WAM on Moderate Risk Loans 41 mths 31 mths 10 mths

Domestic Small Banks May-14 May-13 Change

% of Loans to Moderate Credits 39% 44% -4%

WAM on Moderate Risk Loans 27 mths 29 mths -2 mths

Large Banks Are Competing for C&I Lending By Cutting Terms

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One way large banks may seek to exit C&I loans is via CLO issuance, which has revived in recent quarters, but still isn’t as efficient for issuers as funding on-balance sheet.

Auto lending expansion at the larger US banks is a bit tougher to parse, and, in many respects, more concerning. Vehicle sales rates (SAARs) have accelerated to an average of 16.5 million units in 2Q, up 7% from the 2013 pace. Fed consumer credit data has posted a roughly 8% YoY rise; that figure, and other evidence, suggests a very large portion of the expansion in auto purchases is lending-fueled. The bank lending data for 2Q is the clearest evidence to date, however, of how extreme the lending growth has become, and, more precisely, on which balance sheets the loans are ending up. As the above table notes, auto loan growth among banks >$100 billion was a massive 18.8% in 2Q—and it’s not a function of a small base, as the total dollar amount of loans in that group measured $271 billion.

The good news for auto credit is that, at least according to the July Senior Loan Officers Survey, the plurality of large banks are reporting that prime auto lending standards are “near the midpoint” of their historical range, while of the 16 large banks that make subprime auto loans, the majority are “near the midpoint” or “somewhat tighter” than historical standards. A recent note from New York Fed researchers using Equifax data concluded that lower-FICO score auto originations were rising, but that they still remain a normal percentage of total auto loan originations (the numbers were as of year end 2013). There’s reason to be concerned about future loosening credit standards with autos, but the evidence is not nearly as conclusive as is the case with C&I lending.

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In sum, there’s little evidence from the loan growth data 2Q 2014 to suggest there’s a meaningful breakout in credit demand. On the margin, however, it appears the credit contraction that was a feature of the post-2008 environment is over, and that economy wide loan growth is and should remain positive. Competition, particularly in C&I lending, remains stiff, and based on loan volumes, larger banks have been more aggressive in pricing and terms. The deterioration of lending terms in the C&I sector poses an economic and balance sheet risk, but we’re likely at least two years away from any meaningful credit downturn. Easing C&I lending terms—and you can be sure large bank balance sheet managers are conscious of the phenomenon—raise questions about an exit strategy for many of these term loans ahead of the next potential downturn. CLO markets may provide one answer, though CLO securitization funding (as opposed to on balance sheet funding) makes that solution uneconomical at this point.

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Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Auto Sales (3m SAAR; Left Axis) Non-revolving Consumer Credit Growth (3m Avg; Right Axis)

Higher Non-Mortgage Borrowings Are Correlated with Higher Auto Sales

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Analyst Certification

I, Guy LeBas, the Primarily Responsible Analyst for this report, hereby certify that all of the views expressed in this report accurately reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of our compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

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