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Lending During Growth Periods Versus Lending During Recessions

Banks and other lending institutions are affected by changes in the business cycle, simply because lending during growth periods is very different than lending during recessions. A recession can lead to a tightening of the purse strings, while a positive business environment can result in an increase in lending.

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Recessions Are Not Good for Businesses or Lending…

Recessions are periods of contracting gross domestic product (GDP) and business growth. Precipitating factors of a recession vary. Sometimes it’s a crisis. The Great Recession of 2008-2009, for example, was driven by the subprime mortgage crisis. Homeowners and businesses defaulted on mortgages, the stock market plummeted, and consumers and businesses became much less likely to spend.

Other recessions are driven by downturns in the stock market or overexpansion in the business cycle. Regardless of the cause, organizations and people feeling an economic crunch become much less likely to spend. When customers curtail their spending, businesses, whether their end products are purchased by businesses or consumers, will feel the pinch of fewer orders.

As a result, businesses may need to pare back their operations. They may lay people off, delay expansion plans, or even cut back on the size of their offices and the number of locations. Consequently, fewer new business loans are sought. Banks and other lenders are highly likely to see a drop-off in business.

Lenders may also suffer in other ways during a recession. Contractions in the business cycle also affect the ability of borrowers to pay back their loans. Late payments and defaults on business loans and consumer loans of all types may rise as a result.

At the same time, certain lending conditions may become easier. The United States Federal Reserve usually follows a policy of easing interest rates when recession conditions loom. As a result, interest rates become lower the longer a recession goes on. The idea is to make loans for expansion cheaper, so that businesses can more easily begin to grow again, and lift the economy out of a recession.

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…While Expansions Can Be Very Good

At some point, the easing of interest rates succeeds in making the price of loans attractive to businesses. As a result, businesses want loans to expand.

At this point, business can become very good for lenders on some fronts. Loan originations pick up. While interest rates may still be historically on the low side, which hinders profit margins, the lending business starts to revive.

As expansion begins to take place, the economy recovers from recession. The gross domestic product expands. More people are working, and there is thus more disposable income circulating. As more disposable income circulates and businesses recover, the business cycle gets better and eventually reaches a peak.

An expanding economy is very good news for lenders. Loan originations of all types usually rise.

In addition, the Federal Reserve often begins to raise interest rates, partly in an effort to curtail inflation during expansion. While the timing of interest rate changes can vary, loan originations and interest rates are often increasingly robust at the same time.

Delinquent payments and defaults drop during robust economic periods. Both businesses and consumers are more able to make loan payments.

Eventually, of course, the business cycle begins all over again. An overheating economy might lead to conditions that precipitate a crisis — the most famous, of course, being the impressively expanding U.S. manufacturing sector during the Roaring 1920s. An overheated stock market led to the Great Depression of the 1930s, the most extensive recession in U.S. history.

The Business Cycle and Lenders

Currently, the U.S. is in an economic expansion. Lenders are in a sweet spot in terms of business growth and profitability, as well as minimal delinquencies and charge-offs.

Banks need to be aware of the business cycle in order to maximize their profits and effectively avoid risks as the business cycle progresses.

Contact us for more information.