Weak bank lending is being caused by availability factors and tight credit availability remains, but muted demand is also playing a significant role, according to a report by Ruth Lea, economic adviser to Arbuthnot Banking Group.

At face value bank lending certainly remains weak. M4 lending to households, having averaged around GBP8bn to GBP9bn a month from 2005 to mid-2007 during the height of the credit boom, was around GBP1bn in May and June this year.

Meanwhile lending to private non-financial corporations, a volatile series at the best of times, has been negative for many months.

Net lending secured on property collapsed during 2008, after the unsustainably high levels of the boom. And even though it picked up modestly in late 2009 and early 2010 it has recently weakened again. Unsecured lending, consumer credit, struggled into positive territory in early 2010 after having been negative for much of 2009, when households sought to rein back their indebtedness.

Lea says the continued weakness in mortgage lending reflects several factors but, as the Bank of England has pointed out, it is difficult to identify precisely the separate supply and demand influences.

Supply is undoubtedly tight and lending criteria have been tightened, but availability has modestly improved in recent quarters according to the Bank’s Credit Conditions Surveys. The most recent survey specifically showed improvements for borrowers with high loan to value ratios.

Demand continues to be constrained by the lenders’ restrictions on mortgage finance, particularly for first time buyers. Moreover, demand has tended to fall away this year reflecting continued economic uncertainty despite signs of recovery.

Another relevant factor is housing equity withdrawal. This continues to be negative as mortgage holders cut back on their indebtedness, though the rate of repayment has moderated since the first half of 2009. Lea says these holders are probably concerned about economic uncertainty but they are undoubtedly enabled to pay debt off because of low interest rates.

Turning to the bank lending for businesses, the Bank’s Credit Conditions Surveys suggest that, even though credit availability has improved this year, demand has tended to fall away. Specifically demand by medium and, especially, large private non-financial corporations has decreased. Small businesses’ demand is however higher.

The bank’s network of agents has reported that bank finance demand has remained muted because many businesses have been paying down bank debt and reducing their leverage. In addition, some larger businesses have used capital market issuance (bonds and equity) to fund their activities. Lea says the negative lending figures for medium to large companies can therefore be overwhelmingly explained by demand, not supply, factors. This situation may however reverse as there are currently signs of more difficult capital market conditions for larger companies.

There is still the criticism that banks are starving small businesses of funds to answer. As a recent Green Paper from the Treasury and BIS points out, small firms are very dependent on bank lending for their external finance, having little recourse to the capital markets.

The latest data from the British Banking Association shows that new bank lending to small businesses has been relatively subdued in recent months. Moreover, substantial loan repayments from businesses “seeking to reduce financing costs and reliance on borrowing by operating out of cash flow” have more than offset the new lending.

But the fact that businesses are in a position to make these loan repayments out of cash flow, together with an increase in small business deposits from GBP54bn in June 2009 to GBP56bn in June 2010, does not suggest a sector in financial stress, says Lea. The conclusion must be that the small business sector, as well as medium to large private non-financial corporations, is seeking to cut back on borrowing and deleverage, she adds.