How Understanding Loan Demand and Credit Quality Will Make You A Better Banker

Managing Credit Volume

A common line of thinking in the banking industry, especially regulators, is that recessions are driven by, or at least exacerbated by, the supply of credit. Banks, in an effort to stay competitive, tend to drop their lending standards to hit their loan growth targets. In doing so, these banks take on more and more risk. This occurs until the credit cycle turns, and then banks run into credit problems. However, what happens if banks are watching the wrong competitors? While surely recessions are a function of credit supply, maybe recessions have more to do with demand?


The Loan Demand Cycle


Joe Breeden of Prescient Models has helped us understand the relationship between demand and credit. Prescient Models puts forward the thesis that in any business cycle, the stronger borrowers refinance first leaving the weaker borrowers to finance or refinance later in the credit cycle. Carrying this thought forward, the result is the relationship that shows when demand for credit is high; credit risk is low. Conversely, when loan demand slows, credit risk increases.


In the Prescient Models graphic below, you can see credit quality in blue (as depicted using the Age-Period-Cohort (Vintage) model applied to US mortgage performance) against the Fed’s Senior Loan Officer Opinion Survey detailing loan demand. What the chart shows that in most cases, the change in the demand for credit precedes a change in credit quality. 


Credit cycle and credit risk


The key takeaway here is that it is the net change in rates that impact credit quality. If you look back over the last recession, you can see that as rates rose between 2004 and 2006, demand for credit fell as did credit quality. Here is another look at similar data, that shows the same data as the above graphic with regards to credit quality, but maps it against the volume of loan originations using 1990 volume as the constant (equating to the value of 100).


The below graphic not only illustrates the correlation similar to the above but also visually highlights the impact of credit quality and demand for credit. 


Credit quality and loan demand graph


The key takeaway here is that demand and the credit cycle leads an economic cycle by an average of 17 months.


Putting This Into Action


With the Fed on hold, lower rates have pushed out credit quality concerns. While the missing piece of data is that we don’t know when the cycle turns, loan demand has been trending down for most all categories to include commercial real estate, C&I, consumer, and other sectors. Regardless of where we are, as we are now in the longest economic expansion in US history, credit caution is warranted.


Since demand is falling, banks would do well to tighten pricing, while increasing credit quality in order to stimulate demand for the higher-quality borrower. Many banks did the opposite back in 2006 to disastrous consequence. In addition, it also pays to keep an eye on your competitors (as we wrote about HERE) to see what entities are reducing lending, which could increase supply of credit challenged borrowers to your bank.


By being more dynamic in pricing and credit standards (debt yield, cash flow quality/level, and loan-to-value, in particular) banks can better control the quality and amount of loan volume. Bankers can further fine-tune this flow by focusing more marketing and sales resources that can stimulate the demand for those higher quality relationships that will serve you well during the next downturn.