Despite the cumulative 75-basis-point cut by the United States Federal Reserve since September and the 125-basis-point cut by the Bank of Canada since June, the most recent loan officer surveys for both countries showed lending standards actually tightening.

The reason for this is clear in the “hard” bankruptcy data: credit quality has become a concern for banks, with the number of businesses filing for bankruptcy reaching concerning levels. This is one of many reasons why we think the Fed and the Bank of Canada are currently “pushing on a string,” and that more cuts are needed to respond to deteriorating business credit quality.

In the past few weeks, a string of bankruptcies has been headlining the financial news. From health care (CareMax Inc.) to commercial flights (Spirit Airlines Inc.) to tire manufacturers (American Tire Distributors Inc.) to auto financing (Vroom Inc.), the development has been broadly based.

Looking at the bigger picture, over the 12 months to September, the total number of bankruptcy filings in the U.S. reached 22,691, a 73.5 per cent increase from two years ago when the Fed was midway through its hiking cycle. In quarterly terms, U.S. business bankruptcy filings rose 14.5 per cent in the third quarter from a year ago to 5,557, which is nearly double the cycle low of 3,065 seen in the first quarter of 2022.

The last time there was such a drastic increase in bankruptcies was in the middle of the global financial crisis back in 2008.

Likewise, business insolvencies (including both bankruptcies and proposals) in Canada have risen 16 per cent year over year as of the third quarter, and 12-month total filings to September have reached levels not seen since early 2010. So it makes sense to see lenders tightening their standards against this backdrop.

And it’s not just the supply of credit that’s tightened; demand has been lukewarm as well. In the U.S., a net minus 21.3 per cent of lenders reported a decline in demand for commercial and industrial (C&I) loans and a net minus 10.9 per cent for commercial real estate (CRE) loans, according to the Fed’s survey.

Businesses haven’t been too active in issuing short-term debt either. The 12-week total count of U.S. commercial paper issuances at 55,742, as of Nov. 15, remains lower than the nearby surge of 57,843 we saw in mid-June.

The truth is that borrowing costs remain elevated despite central banks embarking on their cutting cycles. According to the National Federation of Independent Business’s small business survey, interest rates paid on short-term loans remained near historical highs in October at 9.7 per cent, marginally falling from the 23-year high of 10.1 per cent in September.

Small businesses are facing a higher interest rate today than they were a year ago when it was at 9.1 per cent, and the Fed funds rate back then was sitting at 5.5 per cent. This is consistent with the loan officer survey that failed to show any reductions to small firm lending margins since the second quarter of 2022.

That’s been less of a problem for large firms that are able to issue their own debt, with corporate spreads remaining at historically tight levels.

But what’s notable is that the Federal Reserve Bank of New York’s index of corporate bond market distress has worsened since mid-September, with the index ticking up from 0.1 prior to the Fed’s September cut to 0.12 as of late October (higher means more distressed). That is still near the low end of the historical range, but it looks like the rate cuts haven’t had much effect on corporate credit conditions yet.

Meanwhile, the Bank of Canada’s own measure of business interest rates fell by 80 basis points since May to 5.7 per cent in October, but that’s still much higher than what businesses were operating with (a little above three per cent) prior to COVID-19 and the 2022 hiking cycle. For a country lacking a strong consumer base to offset the weakness of the business sector, the cost of borrowing remains far too high.

That combination of stagnant demand and tighter supply for credit would point to a decline in borrowing/lending. Business bank credit is now contracting 1.4 per cent year over year as of September in Canada and has come down in each of the preceding five months. In the U.S., C&I and CRE bank credit growth has decelerated from its December 2022 peak of 13.4 per cent year over year to 1.3 per cent in October of this year, and the pace continues to slow.

Looking forward, banks would be expected to keep their lending standards tight if the current trend of bankruptcies continues to erode credit quality. That would mean less available credit for businesses and de facto upward pressure on borrowing margins, blemishing the effect of rate cuts — again, eerily reminiscent of what happened in 2008.

Remember, monetary policy always works with a lag; hence, we think the current situation calls for the Fed and the Bank of Canada to preemptively provide more easing in upcoming meetings before it becomes “too late.”

Paul Kim is a senior analyst at independent research firm Rosenberg Research & Associates Inc., founded by David Rosenberg. To receive more of David Rosenberg’s insights and analysis, you can sign up for a complimentary, one-month trial on the Rosenberg Research website.

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