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There is no doubt that credit flowed freely in the 1980s and helped pave the way for significant economic growth during much of the decade. Unfortunately, some of the lending was overly aggressive. As Federal Reserve Chairman Alan Greenspan commented in his Humphrey-Hawkins testimony last summer: "It is now clear that a significant fraction of the credit extended during those years should not have been extended. We need merely look at the recent string of defaults and bankruptcies, and the condition of many of our financial intermediaries, to confirm this impression."

With the thrift industry in disarray, and many other types of financial institutions facing severe difficulties, regulators and the institutions themselves began a wrenching process of evaluating capital adequacy, reviewing lending standards and scrutinizing loan applications and potential borrowers much more thoroughly than before. The free spending and lending days of the 1980s are over.

Now there is concern that the pendulum has swung too far. It is human nature to be a little gun-shy after being burned, but too many institutions restricting credit flows too much can harm the economy. In the Humphrey-Hawkins testimony, Greenspan expressed his concerns. "In certain areas, however, the credit retrenchment appears to have gone beyond a point of sensible balance. In some cases, lender attitudes and actions have been characterized by excessive caution. As a result, there doubtless are creditworthy borrowers that are unable to access credit on reasonable terms.... While a single bank may be able to do this without too much trouble, when the entire industry is simply cannot be done without massive untoward effects."

In accordance with this view, the Federal Reserve (Fed) has been carefully monitoring money growth and credit. Not all indicators look favorable. The M2 measure of the money supply - the most closely watched monetary aggregate, consisting of currency, checkable deposits, money market funds, savings deposits and several other items - showed virtually no growth during the late spring and summer. As a result, it fell below the bottom end of the Fed's target range for the period.

Because movements in M2 often have a strong influence on future economic activity, many economists worry that the fragile economic recovery currently underway will unravel if money growth does not pick up. To the extent that credit restraint underlies the lackluster performance of M2 - as some believe is the case - concerns that lending standards have become too tight may be well placed.

The Fed now conducts regular surveys of senior loan officers of large commercial banks to monitor changes in lending standards. One area where credit availability has clearly changed dramatically is in commercial real estate lending. Chart 1 shows the share of banks that reported tighter lending standards over several overlapping periods during the past year and a half or so. In the initial period - March 1990 to August 1990 - about three-fourths of banks tightened; none eased standards. By the final period - May 1991 to August 1991 - banks were still tightening, but the share fell to only about one-fourth. Still, none were easing. In other words, credit was still getting progressively tighter, but at a slower pace.

Similarly, lending standards for non-merger-related business loans were tightened further during the final period, but the pace of tightening slowed from earlier periods. The implication is that credit tightening by lending institutions may go on a little bit longer, but probably will soon stabilize. The new standards will be significantly more stringent than in recent years, but will not get too much more restrictive from those now in place.

Another piece of information in the latest Fed survey concerns residential real estate lending. In response to a question about whether banks' credit standards changed for approving mortgage applications from individuals to purchase homes, the vast majority of banks indicated no change, but 14 percent indicated that they tightened somewhat in the past three months, while 2 percent indicated that they eased somewhat. In an earlier survey covering the first several months of 1991, about 23 percent of the banks had indicated tightening.

Of those that tightened during the most-recent survey period, 25 percent required higher income standards to qualify, 12 1/2 percent required higher down payments, 37 1/2 percent required more stringent appraisal requirements and 50 percent implemented other tightening measures, with many banks taking more than one of these actions.

All of this suggests that credit for many purposes is much tougher to get now than it was a few years ago. Some tightening was clearly warranted, but the danger is that standards may become or may have already become too stringent. Obviously, the Fed is quite concerned about this possibility. Probably the main reason for recent Fed easing of monetary policy has been to encourage prudent lending and to avert a full-blown credit crunch.

If the economic recovery falters, tightening of credit standards may turn out to be the culprit. This recovery cannot withstand too many jolts.

PHOTO : CHART 1 Banks Reporting Tighter Standards
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Title Annotation:financial institutions' overly stringent credit standards could cause a full-blown credit crunch and halt economic recovery
Author:Holloway, Thomas M.
Publication:Mortgage Banking
Article Type:Column
Date:Oct 1, 1991
Previous Article:Secondary market.
Next Article:Boardroom view.

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