Domestic businesses have steadily increased their borrowings even though overall bank business lending appears to be declining. In general, businesses seeking to borrow money (bank deposits) have two main sources: banks or the debt capital markets. A bank loan leads to the creation of new bank deposits and increases the overall money supply, while issuing a corporate bond changes the ownership of existing bank deposits. These two markets for money operate under different constraints and serve different but overlapping borrower segments. In the past year, larger businesses rotated away from from banks to the capital markets while smaller businesses continued to borrow from banks. In this post we describe the two markets for money and show that together they show significant strength in the demand for money from domestic businesses.
Primary Market: Commercial Banks
Bank loans can be thought of as a primary market for money because loans result in the creation of newly issued money. This new money can boost asset prices and economic growth as it circulates throughout the economy. It is extinguished when the loan is paid back.
Banks lend when they can earn a return that meets their requirements. Lending returns are most obviously related to the steepness of the interest rate curve, but are also impacted by various costs. A steepening curve implies increasing loan interest income relative to interest paid on deposit liabilities. (One of the mechanisms Fed cuts stimulate the economy is by steepening the curve and encouraging bank credit creation). Bank lending also has to cover a range of operating costs (e.g. office leases, salaries, advertising) and balance sheet costs (i.e. larger and higher credit risk loans have higher capital costs).
These costs make their way into the interest rates banks can offer borrowers, even when benchmark yields are low. Banks loans are thus a relatively expensive form of financing despite having high seniority. Bank loans tend to be more popular among smaller businesses who have limited alternative sources of financing. Smaller businesses have steadily increased their borrowing from banks over the past two decades and especially the past year.
The recent jump in borrowing by smaller businesses is largely due to the PPP loan program, which offered them forgivable loans at rock bottom rates. Around $800b in loans were made and half have been forgiven. The chart above understates the loans to smaller businesses because forgiven PPP loans do not show up on a bank’s balance sheet. Note that this surge in lending mirrors the surge in bank deposits held by small bank accounts.
Secondary Market: Debt Capital Markets
The debt capital markets can be thought of as a secondary market for money because the borrower is receiving existing bank deposits. No new money is created and the money supply is unchanged (unless a bank is investing, but they are not major investors). In a sense, existing money is being more efficiently used. Almost all classes of investors are active in the corporate bond market, from individuals to pension funds to foreign investors. They usually evaluate bond offerings relative to Treasury yields and demand a spread as compensation for credit risk. Bond investors are concerned with beating their benchmark or absolute returns, but don’t have the high regulatory capital costs or overhead of banks.
Borrowers in the debt capital markets tend to be larger business that are often publicly traded and well known. These borrowers can easily borrow from a bank as well, but it is cheaper for them to borrow from the market. Larger businesses overall have not significantly changed their level of bank loans over the past two decades, despite a brief spike last March when market turmoil closed the capital markets and forced them to temporarily borrow from banks. In contrast, they have significantly increased their bond issuance.
Corporate bond issuance began to skyrocket after the GFC. This is the result of both low Treasury yields from the Fed’s zero interest rate policy as well as the enormous growth of bank deposits from QE. When the Fed conducts QE it is adding reserve assets on the balance sheet of banks, but also deposit liabilities. QE significantly increased the supply of bank deposits in the secondary market for money. This surge in supply can be seen in narrow credit spreads and steady growth in corporate bonds outstanding.
Although the growth in corporate issuance disintermediates banks, it also strengthens the transmission of monetary policy. Larger businesses can borrow at rates that more closely follow the expected path of policy, which can be directly impacted by forward guidance.
Businesses Have a Lot of Money
Increasing demand for money by businesses is usually a risk positive indicator, as more money usually leads to more spending on goods and services (and stock buybacks). The decline in overall bank business lending obscures the underlying strength in business credit growth. Borrowing from smaller businesses have surged from PPP loans, while larger businesses have borrowed record amounts from the corporate bond market. A lot of the money borrowed appears to be hoarded, but that may change with improving sentiment. At the very least there is potential for a significant reflationary move.