Recession Likelihood: Watch for How Much Banks Restrict Lending

The other component that could amplify the slowdown is more restrictive bank lending due to their lower risk appetites, concerns about clients’ creditworthiness, and regulatory supervision.
Recession Likelihood: Watch for How Much Banks Restrict Lending
Bay Street in Canada's financial district in Toronto in a file photo. (The Canadian Press/Nathan Denette)
Rahul Vaidyanath
News Analysis

The flow of credit in the Canadian economy is slowing. This is the effect of much higher interest rates—as engineered by the Bank of Canada—but the other component that could amplify the slowdown is more restrictive bank lending due to their lower risk appetites, concerns about clients’ creditworthiness, and regulatory supervision.

Oxford Economics (OE) says that tightening lending standards often provide warning signs for a recession. With respect to the United States, OE predicts the net percent of banks tightening standards for lending to small firms should hit 60 percent.

“Business investment is sensitive to changes in lending standards and real interest rates. It’s also often the first economic indicator to drop ahead of recession, followed by consumer spending,” said Ryan Sweet, OE’s chief U.S. economist, in an April 14 note.

Fitch bank analyst Mark Narron told The Epoch Times that Canadian banking has not been impacted by the U.S. banking malaise based on anecdotal evidence, but adds that it’s too early to say what’s happening with bank underwriting. Bank earnings season, which doesn’t come until May, will be telling, he added. 

While two factors influencing the flow of credit in the economy are the increase in interest rates and changes to lending standards, Narron says the former is primarily creating a demand problem. 

“Our view continues to be a slowdown in the economy as a result of the interest rate hikes. What is it going to impact? It’s demand for credit, not supply of credit,” Narron said.

The Bank of Canada noted in its April monetary policy report that consumer spending on big-ticket items is going to take a hit.

Waiting Game

What has manifested so far in Canada is a rise in corporate bond credit spreads—the incremental interest rate above the rate on risk-free Government of Canada bonds that a company has to pay to borrow in the capital markets.

Credit spreads generally widen during periods of uncertainty, as was the case with the U.S. banking turmoil of mid-March. Higher credit spreads feed into reduced investment spending and hiring decisions. They effectively work like another rate hike.

RBC senior economist Josh Nye said the Bank of Canada’s senior loan officer survey, to be released on May 12, will be key to see the extent to which lending conditions have become more restrictive.

“It’s safe to assume we’ll see some further tightening in that regard [fees and spreads], though the extent is uncertain. In any case, we think tightening in Canadian banks’ lending standards will be less than in the U.S. given the latter’s more direct exposure to banking turmoil,” he said in an April 12 note.

‘Manageable, Not Extraordinary’

The Office of the Superintendent of Financial Institutions (OSFI) published its annual risk outlook for 202324 on April 18. At a press conference, Superintendent Peter Routledge said in response to a question from The Epoch Times that “it is a fine balance” between protecting the financial system and not harming it by encouraging further tightening of lending standards.

He said the OSFI has seen a slowdown in credit growth across all lending sectors, which isn’t unusual in a rising rate environment.

“Anecdotally, I would characterize it so far as a manageable, not extraordinary, slowdown in lending, driven in part by the supply side of credit, and in part by the demand side—which is [that] borrowers may not have the same appetite,” Routledge said.

For the OSFI, liquidity and funding risk is the second most critical of the nine risks facing Canada’s financial system in the coming year. The risk is that sharp market downturns can put pressure on the marketability of assets and lead to restricted access to funding. 

Financials were the worst-performing group on the Toronto Stock Exchange in March. Stocks of Canada’s big six banks and a few smaller deposit-taking institutions all trended lower. 

The International Monetary Fund said in an April 11 blog post that the stock declines have raised the cost of the banks’ funding and “may well lead to curtailed lending.”

Contagion Contained

Bank of Canada senior deputy governor Carolyn Rogers, speaking from the standpoint of stability of the financial system, said on April 12 that the “immediate stress has been contained and that’s a good thing.”

The risk the BoC outlines is that, “If global banking stresses intensify further, global credit conditions could tighten significantly. … The Canadian economy would be affected through tighter financial and credit conditions.”

It is crucial for smaller financial institutions to be able to offer competitive financing to their clients, which tend to be smaller businesses.

A report by the Canadian Federation of Independent Business released March 16 concluded that issues with accessing financing (44 percent) was one of the top three reasons why small businesses switched banks between 2019 and 2022.

For smaller financial institutions, the top reason for small business customers switching from them was the ability to access financing.

The bulk of the interest rate hikes have not fully impacted the economy, with the consensus being that it takes 12 to 18 months.

“It’s going to happen, and probably a year from now, we'll be living in a very different kind of environment,” Narron said, adding that we could then be seeing an environment of falling rates.

Rahul Vaidyanath is a journalist with The Epoch Times in Ottawa. His areas of expertise include the economy, financial markets, China, and national defence and security. He has worked for the Bank of Canada, Canada Mortgage and Housing Corp., and investment banks in Toronto, New York, and Los Angeles.
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