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During the last couple of years, concern has increased that the exceptionally rapid growth in business loans at commercial banks has been due in large part to excessively easy credit standards. Some analysts argue that competition for loan customers has greatly increased, causing banks to reduce loan rates and ease credit standards to obtain new business. Others argue that as the economic expansion has continued and memories of past loan losses have faded, banks have become more willing to take risks. Whichever explanation is correct, the acceleration in loan growth could lead eventually to a surge in loan losses, reducing bank profits and sparking a new round of bank failures. As the experience of the early 1990s made clear, such a slump in banking could not only threaten the deposit insurance fund but also slow the economy by discouraging banks from granting new loans.

The view that faster loan growth leads to higher loan losses should not be dismissed lightly; nor should it be accepted without question. If loan growth increases because banks become more willing to lend, credit standards should fall and loan losses should eventually rise. But loan growth can increase for reasons other than a shift in supply-for example, businesses may decide to shift their financing from the capital markets to banks, or an increase in productivity may boost the returns to investment. In such cases, faster loan growth need not lead to higher loan losses.

This article explains why supply shifts are necessary for faster loan growth to lead to higher loan losses and determines if supply shifts have caused loan growth and loan losses to be positively related in the past. On balance, the article finds limited support for the view that supply shifts have caused loan growth and loan losses to be positively related. Data on business loans and delinquencies show that states experiencing unusually rapid loan growth tended to experience unusually big increases in delinquency rates several years later. This finding is tempered, however, by evidence on business loan growth and business credit standards suggesting that changes in loan growth are not always due to shifts in supply.

The first section of the article explains how loan growth and loan losses might be related. The second section examines the relationship between business loan growth and business credit standards, drawing on the Federal Reserve’s Senior Loan Officer Survey for the periods 1967-83 and 1990-98. The third section investigates the relationship between business loan growth and business loan delinquencies, using statewide data for the period 1982-96.

POSSIBLE RELATIONSHIP BETWEEN LOAN GROWTH AND LOAN LOSSES

An obvious reason loan growth and loan losses might be related is the business cycle. Loan growth tends to be high during business expansions, while loan losses tend to be high during business contractions. Thus, as a result of the business cycle, periods of rapid loan growth naturally tend to precede periods of high loan losses. But does faster loan growth lead to higher loan losses even after controlling for the state of the economy? Using a simple model of the market for bank loans, this section identifies when such a relationship between loan growth and loan losses is likely to exist. The section then suggests how data on loan growth, credit standards, and loan losses can be used to test the view that faster loan growth leads to higher loan losses.

Why faster loan growth might lead to higher loan losses

Most of the reasons usually given for faster loan growth leading to higher loan losses involve supply shifts-that is, increases in banks’ willingness to lend. When such a shift occurs, banks typically seek to increase their lending in two ways. First, they reduce the interest rate charged on new loans. Second, they lower their minimum credit standards for new loans-for example, they reduce the amount of collateral the borrower must have to back his loan, accept borrowers with weaker credit histories, or require less proof that the borrower will have enough cash flow to service his debts. Such a reduction in credit standards increases the chances that some borrowers will eventually default on their loans. Thus, assuming banks lower credit standards as well as reduce loan rates, increases in lending due to supply shifts will tend to lead to higher loan losses in the future.

Figure 1 shows the effects of such a supply shift on total lending and credit standards. The left-hand panel shows how bank credit standards are related to the expected rate of return on loans. The diagram assumes that the creditworthiness of borrowers can be represented by a single number, z, measured along the horizontal axis. The higher z is, the more likely the borrower will be able to repay his loan-for example, the safer his investment project is or the more collateral he has to back his loan. Banks base the decision to make a loan on the expected rate of return on the loan, re. The expected rate of return on a loan depends on both the loan rate and the prospects for repayment. If the borrower were certain to repay his loan on time, the expected rate of return on the loan would be the same as the loan rate. As long as there is some chance of default, however, re will be the less than the loan rate. In the diagram, the expected rate of return is measured on the vertical axis.

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SAN RAMON, Calif.–(BUSINESS WIRE)–March 9, 1999–Beginning March 1, the state of New Jersey taxpayers can pay their 1998 state income tax with their credit cards by calling 888/2PAY-TAX (SM). Credit card payments are now available under an agreement between U S Audiotex(SM) LLC, an affiliate of Los Angeles-based Imperial Bancorp (NYSE:IMP), and the state of New Jersey.

“We’re obviously delighted to have been selected by the state to participate in such an innovative program,” stated Kenneth Stern, president and founder of U S Audiotex. “Many taxpayers welcome the opportunity to pay their state income tax along with their federal income tax by credit card.

“The convenience and flexibility that are inherent with credit cards coupled with the ease of use and accessibility of 888/2PAY-TAX provide the taxpayer with a viable payment alternative to checks or money orders. U S Audiotex sees the state benefiting from the paperless nature of credit card payments. Also, by accepting credit cards, the state is providing the taxpayer with a convenient payment option,” added Stern.

New Jersey taxpayers, using a touchtone telephone, dial 888/2PAY-TAX and are connected to the U S Audiotex Interactive Voice Response (IVR) System. This computer system prompts the taxpayer (using the numeric keys on the touchtone phone) to select “state of New Jersey Income Tax.” The system then prompts for information including the Social Security Number and the amount of payment.

The computer computes the convenience fee and obtains the taxpayer’s approval prior to the taxpayer entering credit card information. The U S Audiotex IVR System performs an online authorization to verify credit and, upon credit verification, provides the caller with a confirmation number that the payment has been authorized by the credit card issuer.

Only the taxpayer’s Social Security Number and payment data are transmitted by U S Audiotex to the state. Funds are electronically transferred to the state’s bank account. Confidential credit card information is not forwarded to the state.

“We’re pleased with the agreement between our affiliate, U S Audiotex, and the state of New Jersey,” stated George L. Graziadio, chairman of the board, president and chief executive officer of Imperial Bancorp.

“U S Audiotex has successfully been assisting hundreds of governmental agencies around the country through its one-of-a-kind Interactive Voice Response System. This agreement exemplifies Imperial’s style of business, which is to provide innovative financial services and products to our customers,” added Graziadio.

U S Audiotex charges a convenience fee to taxpayers who pay their state and/or federal income tax through this program. The fees charged are very competitive to other credit vehicles.

“A substantial number of our customers find our fees are outweighed by the credit card benefits of air miles, cash back bonus awards or product purchase credits,” said Stern. U S Audiotex fees pay all processing and telecommunications costs in providing this service for taxpayers.

All taxpayers, regardless of the filing form (electronic, paper, through tax preparation services or software programs), may use their MasterCard, American Express or Discover Card through 888/2PAY-TAX. The U S Audiotex system is available to taxpayers seven days a week, 24 hours a day.

U S Audiotex, a closely held San Ramon-based company, was founded in 1986. It currently processes credit card payments for about 300 counties and cities throughout the country. In addition, U S Audiotex processes credit card payments for the IRS and California Franchise Tax Board.

For more information about U S Audiotex and the state of New Jersey credit card acceptance program, visit U S Audiotex’s Web site at www.usaudiotex.com.

Imperial Bancorp, a diversified financial organization, was founded in 1968. Imperial Bank, the principal subsidiary organized in 1963, serves mid-sized businesses by offering a wide range of financial services tailored to corporate customers, entrepreneurs, and professionals nationwide. Imperial can be found on the Web at www.imperialbank.com.

COPYRIGHT 1999 Business Wire

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