Each depositor insured to at least $250,000 per insured bank

Recent underwriting surveys indicate that bankers are eager to grow commercial and industrial (C&I) credit. With the expectation of slowing consumer lending growth, particularly residential real estate lending, C&I loan growth will factor prominently in sustaining earnings growth for commercial banks. Demand for credit, however, will not improve substantially until corporations are no longer able to meet their financing needs from internal cash flows. The need for many companies to tap external funding sources may remain lackluster for several more quarters. Indeed, when viewed across all industries, corporate cash flows appear more than sufficient to meet near-term funding needs.

The need for external funding is often measured by the corporate financing gap (capital expenditures plus the change in inventories less internal cash flow). When summed across all nonfinancial U.S. corporations, the four-quarter moving average of this metric has been declining since second quarter 2000. The corporate financing gap is watched carefully by forecasters of C&I loan demand because it correlates historically with C&I loans outstanding (see Chart 1).¹

Strong corporate profits, scaled-back capital expenditures, and declining inventories across many industries have driven the total corporate financing gap into negative territory, where it has remained since second quarter 2003. Nevertheless, this national trend does not reflect the current need by many companies for external funding. This article identifies the industries that evidence the greatest need for external funding and, therefore, are more likely to drive a turnaround in C&I loan demand. The article further stratifies industries by corporate credit quality to identify industry sectors that need funding but that may find an unfavorable reception in the public debt markets.

Identifying Sources of C&I Loan Demand

Historical trends and industry research confirm that the financing gap is a key indicator of potential C&I loan demand. William Bassett and Egon Zakrajsek of the Federal Reserve Board offered the sharply rising financing gap in the 1997 to 2000 period as an explanation for the increase in C&I loan growth at that time.² This sharp rise in the financing gap was most pronounced in the telecommunications sector. Shortly after, telecommunications dominated the shared national credits in the banking system. More recently, Richard Berner of Morgan Stanley has pointed to a projected increase in the corporate financing gap as evidence of an impending rise in business funding needs in late 2004.³

Although the analysis presented here relies on the strong historical relationship between a firm's or an industry's financing gap and its demand for C&I loans, this relationship should not be overstated. Companies have access to sources of funds other than cash flow, including sale of investments and issuance of long-term debt and equity. Also, capital expenditures and purchases of inventory are not the only potential uses of funds. Companies use available funds to increase investments, make acquisitions, reduce long-term debt, and pay cash dividends (see Box 1 for details).⁴

Because of these factors, a company's or an industry's financing gap should be viewed as a necessary, if not sufficient, predicate to bank borrowing. Analyzing financing gaps provides insights into which industries have the greatest demand for financing purchases of inventories and capital equipment. Other conditions being equal, these industries will be more likely to need bank-provided financing.⁵

The 2003 Financing Gap Suggests Which Industries Had the Strongest C&I Loan Demand Last Year

Table 1 presents industries with the largest financing gaps at year-end 2003. Industry financing gaps are further divided on the basis of credit quality. Credit quality is proxied with the Expected Default Frequency™ (EDF™) bands calculated by Moody's KMV Company (see Box 2 for details). Unfavorable pricing in the public debt markets might further increase the likelihood that a company needing funds would turn to bank financing. Firm credit quality affects the relative cost of accessing the capital markets for funding when compared with the cost of bank financing. Therefore, the highest-credit-quality firms may be most successful finding accommodative pricing in the public debt markets, allowing them to defer bank borrowing longer.

First Quarter Data Suggest Different Industries May Lead C&I Loan Demand in 2004

Retailing, capital goods, and consumer durables and apparel exhibited far more demand for external financing relative to other industries in first quarter 2004 compared with 2003 (see Table 2 and Chart 2).

Although seasonal factors may influence the quarterly financing gap of some industries, historical data suggest that retail companies tend to experience peak external financing needs in the third quarter. Capital goods firms generally face peak financing requirements in the fourth quarter.

The Importance of Inventory Financing Will Likely Grow in 2004

Capital spending finance was the primary source of external funding needs overall in 2003, accounting for more than 82 percent of the total.⁶ In some industries, however, inventory finance was a far more important need. For example, the change in inventories in consumer durables and apparel accounted for 88 percent of the total. Change in inventories accounted for a large part of financing needs in the household and personal products and food, beverage, and tobacco sectors as well.

These industries aside, businesses generally have allowed inventories to decline to very low levels since the economic slump that began in the middle of 2001. However, both business and consumer confidence have largely recovered and economic activity has become brisk, requiring businesses to begin investing in inventories to meet product demand.

First quarter 2004 data bear this out. Inventories' share of external funding needs rose from 18 percent in 2003 to 43 percent in first quarter 2004. Higher inventories were significantly more important relative to capital spending in the consumer durables and apparel, capital goods, household and personal products, and retail sectors (see Chart 3). For some industries, the change in the source of external funding needs was stark. For example, the change in inventories at retail firms increased from 31 percent of funding needs in 2003 to 66 percent in the first quarter of 2004. For the capital goods sector the change in inventories increased from 41 percent to 77 percent from 2003 to first quarter 2004.

Conclusion

When C&I loan growth resumes, the industries with the strongest demand will be those with the greatest need for financing purchases of capital equipment and inventories. This demand will likely come from the retailing, consumer durables, transportation, technology hardware, and capital goods sectors.

The composition of C&I loan demand is likely to shift in 2004. First quarter 2004 data suggest that inventory financing will grow in importance this year as the economy continues to strengthen and the business sector invests in inventory to meet emerging demand. How-ever, there should also be significant demand for capital equipment financing.

Stephen C. Gabriel, Senior Financial Economist

¹ Applebaum, Lori, et al., The Next Leg of Growth: Middle-Market Banking, Goldman Sachs Global Investment Research, May 13, 2004.

² Bassett, William, and Egon Zakrajsek, "Recent Developments in Business Lending by Commercial Banks," Federal Reserve Bulletin, December 2003.

³ Berner, Richard, "Business Borrowing-On the Way," Global Economic Forum, Morgan Stanley, April 30, 2004.

⁴ Mergers and acquisitions are also considered sources of C&I loan demand. Mergerstat ranked the top industries as of June 20, 2004, in terms of base equity price offered. The top six industries were banking and finance, leisure and entertainment, communications, computer software, supplies and services, and retail.

⁵ Not all C&I loan demand will be met by commercial banks and savings institutions. Nonbank financial institutions compete with banks for C&I loan business.

⁶ Total C&I loan demand is assumed to be the sum of capital expenditures and the change in inventories during the period for firms with a positive financing gap.

⁷ The Moody's KMV Credit Monitor® EDF™ estimates the probability of default within one year. Moody's KMV Company's calculation for EDF™ is based on (1) the current market value of the firm, (2) the structure of the firm's current obligations, and (3) the vulnerability of the firm to large changes in market value measured in terms of asset volatility.