Silas Keehn, President, Federal Reserve Bank of Chicago - Statements to the Congress - transcript

Federal Reserve Bulletin, July, 1991

Statement by Silas Keehn, President, Federal Reserve Bank of Chicago, before the Subcommittee on Domestic Monetary Policy of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, May 8, 1991.

I am very pleased to have this opportunity to give you my views on the recent trends in credit availability. While perhaps I need not emphasize the point, as the representative of a Reserve Bank located in the heart of the Midwest, it is entirely possible that the tenor of my comments will be different from what you may hear from other parts of the country.

The Lending Slowdown

We have all heard a great deal about the "credit crunch" during the past year. Unquestionably, there has been a tightening in the extension of credit, particularly commercial credit, by banks during this recent period. Many banks have raised their credit standards, and to a significant extent they have reduced commitments when the use of unborrowed lines would result in large increases in outstanding credit. In addition, they have raised interest rate spreads and tightened covenants and collateral requirements. These price and nonprice changes have had the effect of restraining the extension of credit. While the impact of this has been particularly significant in certain categories of lending, such as commercial real estate and highly leveraged transactions, the effect of this restraint has extended to other parts of the loan portfolio as well.

Several forces have contributed to the restraint on the extension of bank credit. Because of intense competitive conditions in the banking markets, interest rate spreads on many commercial transactions have been driven to very low levels. Many industry observers (and I strongly agree with them) feel that there is a significant overcapacity in the banking business, which, along with other market factors, accounts for these highly competitive conditions. As a consequence, a commercial loan as a stand-alone transaction frequently does not return an adequate level of profit. Indeed, some institutions will decline a perfectly creditworthy loan unless ancillary business will increase the profitability of the overall transaction. This profitability issue is contributing to the current restraint.

It is important to remember that the shift in lending attitudes follows a phase of strong credit extension that took place during the 1980s. It is a logical response that was entirely reasonable to expect given some of the credit problems that have emerged as a consequence of this period of aggressive credit expansion. While the decline in economic activity with the resultant decline in the demand for credit has certainly had an important effect on loan volume, this tightening of credit standards, reflecting a change in attitudes by bank management, has had a major role as well. To emphasize the point, for a variety of reasons we are going through a period of significant credit restraint.

Having said that, I do not think that monetary policy has been the cause of this restraint. In a classic liquidity sense, it is my view that we are not experiencing a "crunch." In the most recent period, bank reserves have been adequate, and very frequently conditions in this segment of the money market have been described as "soft." Monetary policy has been eased rather aggressively and regularly over the past six months. Recognizing that it is a matter of judgment, I do not think that the recent and current credit restraint in the markets can be attributed to a shortage of liquidity that has been induced by an overly restrictive monetary policy.

Credit Restraint

What constitutes a credit "crunch," to my way of thinking, is when creditworthy borrowers, those that would normally find it possible to obtain credit even under adverse economic circumstances, cannot obtain financing. This is not currently the case, at least in the Midwest. A "crunch" is most likely to occur when all lenders serving a particular class of customers find their lending capacity contracting. As a classic example of this phenomenon, before Regulation Q, which imposed ceilings on interest rates, was removed, this is precisely what happened to mortgage borrowers when interest rates peaked dramatically--the good, the bad, and the indifferent as a class were unable to obtain credit.

What currently exists is credit restraint--not a "crunch." But irrespective of this definitional difference, when bank borrowers experience a restraint on the availability of credit, this restraint could have an impact on the performance of our economy. Firms may scale back on their plans and the projects for which the bank funds would have been used; if enough firms are affected, economic growth in the aggregate could suffer. Large firms, however, are less likely to be affected by this sort of problem. They operate in national or even international markets with many alternative suppliers of credit and therefore have greater flexibility. Moreover, credit intermediation outside the banking system may indeed be mitigating the impact of reduced credit extension by commercial banks. This involvement extends beyond the very large borrowers. Our senior loan officer opinion survey indicates that small and middle market firms are increasingly finding finance companies to be an attractive alternative to domestic banks.