High Capital Costs Hinder Loan Growth
Higher capital levels have raised the cost of making loans
Higher capital is already hurting loan demand, with more to come
US banks are holding more capital in response to the tighter capital and balance sheet rules regulators have already put in place, and perhaps in anticipation of even greater capital requirements yet to come. Higher capital levels have raised the cost of making loans, which has, in turn, raised the costs faced by many bank customers and slowed loan growth.
While this trend can be seen across a variety of loan markets, in this piece we focus on corporate lending. We estimate that the yield spread for a Commercial and Industrial (C&I) borrower is 200 basis points (bp) higher today than it was in the decade leading up to 2007, and that every 100 bp increase in this spread causes demand for these loans to decline by more than 9%.
A higher cost of bank capital affects small firms disproportionately
The adjustment process to higher bank capital costs is not yet over. It has already led, not only to an ongoing drag on bank loan growth, but also to competitiveness issues for small-and mid-sized corporate bank customers who lack alternatives to bank financing. This shift will likely increase the share of financing from public debt markets at the expense of the bank loan market, while also favoring the long-run growth of large multinationals over that of small and medium-sized enterprises.
C and JPM are likely to benefit from the “bond-for-bank loan ”trend
We continue to favor Citigroup (C; CL Buy) and J.P. Morgan (JPM; CL Buy), as both firms: (1) are expected to benefit in the near term from expanding global capital markets activity; (2) have limited exposure to small- to midsized corporate borrowers (7% for JPM, 4% for C’s US loans); and (3) are attractively valued on tangible book (1.4X for JPM, 0.9X for C) and have superior capital ratios (9.5% tier one common ratio for JPM, 10.3% for C).
Citigroup also benefits from sizeable exposure outside the United States relative to its regional peers, supporting above average mid-term growth prospects.