×
Home Companies Industry Politics Money Opinion LoungeMultimedia Science Education Sports TechnologyConsumerSpecialsMint on Sunday
×

Bank lending in hard times

Bank lending in hard times
Comment E-mail Print Share
First Published: Mon, Sep 28 2009. 10 16 PM IST
Updated: Mon, Sep 28 2009. 10 16 PM IST
A year after the collapse of Lehman Brothers, murmurs of a reviving global economy can be heard. There has been a belief among the authorities that providing banks with additional liquidity is a sure-fire way of pulling out of the recession. Although increased lending activity is a feature of all business cycle upswings, it is misguided to believe that that in itself is the cause.
Financial markets are characterized by informational problems. Smaller and less-known firms rely heavily on bank lending for working capital. In troubled times, they face steeply rising external cost curves of borrowing as they fail to establish informational credibility, having limited access to capital markets. By contrast, larger corporations face a minimal difference in cost between internal and external sources of finance.
The defining characteristic of a credit crunch is that policy-induced changes in interest rates cease to indicate changes in (external) costs of borrowing faced by small firms. For example, a drop of 100 basis points (one percentage point) in the key rate results in a drop of only 25 basis points on external borrowing costs for small firms, but going the whole hog for large corporations. The channels of monetary policy transmission provide insights into the situation.
The bank lending channel (BLC) attributes increased lending activity to an increase in banking reserves. This channel sidesteps the traditionally recognized interest rate channel (IRC). The broad credit channel (BCC) works through the effect of interest rate changes on the balance sheet, primarily that of the borrower. With lower interest rates, the net (discounted) present value of assets rises. This improves borrowers’ financial outlook, facilitating them to meet informational (collateral) requirements.
In the Keynesian framework, it was argued that monetary policy ceases to be an effective tool for revitalizing economic activity once the zero-bound for the nominal interest rate is attained­—the liquidity trap. The intuition behind the trap is simple. Central banks engage in open market purchases of bonds to provide monetary stimulus to the economy. To absorb the additional money stock, the demand for money must rise—possible only if interest rates fall (interest rates represent the opportunity cost of holding money). At the zero level, there is a liquidity trap in the sense that individuals hold on dearly to money, rather than invest it. Individuals can expect interest rates to only rise in the future, and with such an upward movement, prices of bonds would fall. Thus, agents believe it to be cheaper to invest in the future, and hence refrain from lending in the capital markets now. However, such extreme agent behaviour has never been observed in reality.
Theory later evolved to agree that BLC and BCC justify the effectiveness of monetary policy even in a liquidity trap. Not considered before was the idea that monetary policy affects not just the real economy, but also financial markets.
The idea of quantitative easing is related to this framework. Central banks engage in large-scale purchase of long-dated government bonds to pull down long yields—the rates relevant for productive investment. This contributes to increased liquidity in the banking system (BLC at work) and to lower interest rates, which helps raise collateral values staked by borrowers (BCC at work).
Bank lending tends to follow economic activity (rising incomes, rising asset values) and not the other way round. Only when informational barriers in the economy are mitigated (with reduced interest rates increasing collateral values), and when banks have robust balance sheets, does bank lending spur the business cycle. In this crisis, banks were compelled to use the infused liquidity to make good assets gone sour. BLC and BCC, thus, failed to kick in.
Aditya Sihag is a student of economics at the University of Cambridge. Comments are welcome at otherviews@livemint.com
Comment E-mail Print Share
First Published: Mon, Sep 28 2009. 10 16 PM IST