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Are Banks Starting Another Race to the Bottom?

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For would-be borrowers, there's good news. Banks are more willing to lend and have been loosening lending standards and terms, making it easier to borrow. Unfortunately, this isn't driven by an improving economy. Instead, it's primarily due to competition from other lenders.

Let's hope this isn't the start of another race to the bottom in the banking industry. Congress is still figuring out how to pay for bankers' last race to the bottom.

Why the stiffer competition for borrowers? It's simple. Loans account for about half of bank revenue and demand for credit hasn't picked up much. For the largest U.S. banks, average loans fell 6% year over year in the first quarter.

There are signs of improvement. Consumer demand for auto loans increased in the first quarter. The Federal Reserve's latest survey of bank senior lending officers shows better demand for both commercial and industrial loans to businesses and commercial real estate loans. C&I loans grew only 1% in 2010.

However, there's been no increase in demand for consumer installment (e.g., credit card) loans. Consumer demand for mortgages continues to deteriorate.

Loan demand probably won't pick up in a big way for several years. Let's consider business loans and leases, which averaged about 36% of gross domestic product from 1976 through 2010. In December 2008, the value of these loans and leases hit a peak of 51% of GDP before declining to 45% in March, according to The Wall Street Journal.

The good news: The ratio is declining. The bad news: It's still closer to its all-time-high than its long-term average. Credit Suisse estimates it will take two to three years for this ratio to return to average. With the economy stuck in low gear, that doesn't bode well for business loan demand.

Consumers remain similarly overleveraged. The ratio of consumer debt to income is 12% below its April 2008 peak. Consumers have historically shed 30% to 35% of their debt once they start deleveraging. By one economist's estimate, consumers will continue to reduce their debt for another four to seven years.

Foolish takeaway
Banks' increasing desire to make revenue-generating loans is on a collision course with a weak outlook for loan demand. Whether it's the start of another race to the bottom, this doesn't bode well for the earnings outlook at Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , JPMorgan Chase (NYSE: JPM  ) , or Wells Fargo (NYSE: WFC  ) .

If you'd like to monitor this risk, you can get up-to-date news and analysis by clicking below to add these stocks to your watchlist:

Fool contributor Cindy Johnson has been underweight financials since 2008, which has been a good move overall (albeit not without its rough patches). She does not own shares in any security in this story. No way. The Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Through a separate Rising Star portfolio, the Fool is also short Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (1) | Recommend This Article (4)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 10, 2011, at 8:51 AM, ronbeasley wrote:

    Warren Buffett, Prem Watsa (Fairfax Financial), billionaire hedge fund managers David Tepper and John Paulson, and Bruce Berkowitz (Fairholme Funds) are all highly successful long-term investors with enviable track records. They have enormous bank holdings, and have been adding to them aggressively. It is amusing to see so many internet bloggers, like the author of this article, who think they see something these guys don't. Learn from the best, it is much more profitable.

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