Financial Crisis and the Credit Channel of Monetary Policy Transmission
Dr. Wolassa L. Kumo
December 01, 2008
1. Introduction
The financial shock that erupted in August 2007, as the US sub-prime mortgage market was derailed by the reversal of the housing boom, has spread quickly and unpredictably to inflict extensive damage on markets and institutions at the heart of the financial system [1] in the US and the rest of the world. The current financial crisis, considered to be the largest such shock since Great Depression, dragged the US economy into recession. The Euro zone economy followed suit in mid November with the fall in output for the previous two consecutive quarters. Some thought that Japan would at least delay recession for a while but its output also contracted for the second consecutive quarters confirming that all major industrialised economies are now in recession. The crisis has already spred to the emerging markets and the developing world. Global economic down turn has now become a reality.
The current financial crisis is believed to be the result of the developments in the world since Neo-liberalism became the major guiding philosophy. Analysts believe that the triumph of the market economy in the 1980's following the Washington Consensus set in motion the forces that led to two major financial crises in a decade: the Asian contagion of 1997-99 and the current global financial meltdown [2]. In addition to this, the forces of globalization and globalized capital enabled the financial institutions to engage in a cycle of borrowing, lending and collateralization. Economists now agree that the behaviour of encouraging households to assume debt beyond their means in order to reap huge profits from packaging mortgages into collateralized securities of dubious quality has resulted in conditions that led to the current global economic downturn [2].
In addition to greed, speculation, easy credit and inadequate regulation, low US inertest rate for prolonged period had exacerbated the problem. Yet others blame the very use of fiat money, fractional reserve banking and the existence of central banks with the power to issue free money, as the main causes of the current and previous financial crises.
The most important question however is how the crisis in the credit market could have such rapid and profound impact on the real sector of the economy.
According to [6] economic growth and prosperity are created primarily by what economists call "real" factors--the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. However, he further states, extensive practical experience as well as much formal research highlights the crucial supporting role that financial factors play in the economy.
Financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy and some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator" [6. Apart from this, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission.
Nevertheless, economists do not agree on the existence of operative credit channel of monetary policy transmission. Both theoretical and empirical economic literature on the credit channel of monetary policy transmission is divided into two camps. The first camp believes that the credit channel of monetary policy transmission exists and is operative while the other group believes that there is no evidence that there is operative credit channel of monetary policy transmission. This article reviews the arguments of both sides in light of the current global financial crisis and economic downturn.
The rest of the paper is organised as follows: section 2 presents arguments in favour of the existence of operative credit channel of monetary policy transmission while section 3 presents the arguments of the opposing view. Section 4 analyses the linkages in light of the current financial crisis and concludes the paper.
2. The Credit Channel of the Monetary Policy Transmission: The
Proponents´ view
The study of the credit channel of monetary policy transmission also known as the credit view investigates the importance of bank lending in the propagation of exogenous shocks and the impact of this on the real economy. According to this view, a negative shock such as a monetary tightening, restricts the availability of credit to borrowers, thereby negatively affecting the real economy.
The "credit view" is an alternative to the conventional "money view" or the interest rate channel of monetary policy transmission.
According to [4] the credit view consists of two different views, namely (a) the bank-lending view and (b) the balance sheet view. The bank-lending view states that banks cut back on lending in the presence of tight money because they have less money to lend, even though there are good loans to be made. On the other hand, the balance sheet view implies that banks cut back on lending in the presence of tight money because borrowers are not in a good shape. The two views have different implications. However, both views imply that a monetary tightening reduces the supply of bank loans, thereby negatively affecting the real economy [4]. This transmission mechanism of monetary policy is called the credit channel.
The importance of the credit channel may depend on institutional characteristics of the financial market. For instance, according to [4] if banks can substitute from deposits to less reserve-intensive forms of finance, such as certificates of deposit, commercial paper, and equity, a reduction in bank reserves caused by a monetary tightening will not shift the supply curve of bank loans to the left. Similarly, if borrowers have access to a variety of non-bank financial sources, a leftward shift of the supply curve of bank loans, if any, will not affect the real economy. Thus economic literature suggests that the importance of the credit channel is likely to diminish over time due to ongoing financial innovation and deregulation [5].
However, according to [4], there may be institutional changes that make the credit channel of monetary policy more important. An example of such institutional changes may be the introduction of the risk-based capital standards in 1989 following the Basle Accord, in which the Bank for International Settlements (BIS) requires bank supervisors to impose minimum risk-weighted capital-to-asset ratios of eight per cent on all internationally operating banks of member countries. The BIS gives positive weights and zero weights to risky components (e.g. commercial and industrial loans), and safe components (e.g. U.S. government securities), of banks´ assets respectively. This means that banks can raise their risk-weighted capital-to-asset ratios by substituting from loans to government bonds. If several banks adjust their portfolios in this manner at the same time, the aggregate supply schedule of bank loans will shift to the left, and a credit crunch will ensue [4]. The reduction in supply of loans, then constraints firms dependent on bank loans from investing in the production of goods and services, thereby leading to economic contraction.
3. The Alternative View
According to [3] two fundamental problems make direct tests of the credit view difficult. These are (a) the difficulty of identifying exogenous monetary policy shocks, and (b) the difficulty of identifying the relationship between these shocks and subsequent real activity.
In order to mitigate this problem [3] used an indirect approach to test the credit view. First, they used changes in (stock) market expectations of Fed policy as the measure of policy shocks and identified them using daily accounts in the business press. Secondly, because the stock market reacts quickly to changes in expectations of future profitability, they observe near-contemporaneous responses of stock prices to policy shocks regardless of when in the future profits are expected to be altered. Thus, they mitigate the difficulty of identifying the effects of policy on real activity over time, by relying on the measure of investors' expectations of these effects.
They argue that if the credit channel is important, then firms that are dependent on bank credit and internal funds should receive a relatively greater benefit (loss) from a Fed easing (tightening) than firms with access to nonbank credit at favourable terms. They identify ten policy shocks during the expansion of 1993-94 and the "credit crunch" period of 1990-91 recession and find little evidence in support of an operative credit channel.
In addition to this [7] argues that in the presence of risk based capital requirements and an imperfect market for banks´ equity, there exists an alternative "bank capital channel" by which monetary policy can change the supply of bank loans through its impact on bank equity. This implies that monetary policy effects on bank lending depend on the capital adequacy and the profitability of the banking sector. Furthermore, lending by banks with low capital has a delayed and then amplified reaction to interest rate shocks, to well-capitalised banks.
The "bank capital channel" view extends the balance sheet view by incorporating the capital adequacy requirement and the existence of imperfect market for banks' equity.
4. The Credit Channel, Financial Crisis and Global Recession
Only empirical economic research will determine which channel of monetary policy transmission was responsible for the current global recession: the continued contraction in output and employment in all major industrialised countries. Whether it is the credit channel, bank capital channel or the financial accelerator, we are pretty sure that the invisible hand will not always produce visible outcomes. An adequate level of state intervention is crucial for the sustainability of capitalism, especially in financial sectors which are the life blood of the world economic system.
References
1]http://www.guardian.co.uk/business/2008/apr/09/useconomy.subprimecrisis (retrieved on 10/10/2008)
2]http://yalibnan.com/site/archives/2008/06/root_causes_of.php (retrieved on 10/10/2008)
3] Warner, E. and Georges, C. 2001. The Credit Channel of Monetary Policy Transmission: Evidence from Stock Returns., Oxford University Press.
4] Suzuki, T. 2002. Credit channel and risk-based capital adequacy requirements. Available at: http://dspace.anu.edu.au/handle/1885/40593
5] Bernanke, Ben S., and Mark Gertler. 1995. Inside the Black Box: The Credit Channel of Monetary Policy Transmission, Journal of Economic Perspectives, vol. 9, pp. 27-48.
6] Bernanke, Ben S., 2007. The Financial Accelerator and the Credit Channel. At the The Credit Channel of Monetary Policy in the Twenty-first Century Conference, Federal Reserve Bank of Atlanta, Atlanta, Georgia, June 15. Availably at
http://www.federalreserve.gov/newsevents/speech/Bernanke20070615a.htm
7. Heuvel S.J. 2007. The Bank Capital Channel of Monetary Policy. Department of Finance, The Wharton School, University of Pennsylvania.
The financial shock that erupted in August 2007, as the US sub-prime mortgage market was derailed by the reversal of the housing boom, has spread quickly and unpredictably to inflict extensive damage on markets and institutions at the heart of the financial system [1] in the US and the rest of the world. The current financial crisis, considered to be the largest such shock since Great Depression, dragged the US economy into recession. The Euro zone economy followed suit in mid November with the fall in output for the previous two consecutive quarters. Some thought that Japan would at least delay recession for a while but its output also contracted for the second consecutive quarters confirming that all major industrialised economies are now in recession. The crisis has already spred to the emerging markets and the developing world. Global economic down turn has now become a reality.
The current financial crisis is believed to be the result of the developments in the world since Neo-liberalism became the major guiding philosophy. Analysts believe that the triumph of the market economy in the 1980's following the Washington Consensus set in motion the forces that led to two major financial crises in a decade: the Asian contagion of 1997-99 and the current global financial meltdown [2]. In addition to this, the forces of globalization and globalized capital enabled the financial institutions to engage in a cycle of borrowing, lending and collateralization. Economists now agree that the behaviour of encouraging households to assume debt beyond their means in order to reap huge profits from packaging mortgages into collateralized securities of dubious quality has resulted in conditions that led to the current global economic downturn [2].
In addition to greed, speculation, easy credit and inadequate regulation, low US inertest rate for prolonged period had exacerbated the problem. Yet others blame the very use of fiat money, fractional reserve banking and the existence of central banks with the power to issue free money, as the main causes of the current and previous financial crises.
The most important question however is how the crisis in the credit market could have such rapid and profound impact on the real sector of the economy.
According to [6] economic growth and prosperity are created primarily by what economists call "real" factors--the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. However, he further states, extensive practical experience as well as much formal research highlights the crucial supporting role that financial factors play in the economy.
Financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy and some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator" [6. Apart from this, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission.
Nevertheless, economists do not agree on the existence of operative credit channel of monetary policy transmission. Both theoretical and empirical economic literature on the credit channel of monetary policy transmission is divided into two camps. The first camp believes that the credit channel of monetary policy transmission exists and is operative while the other group believes that there is no evidence that there is operative credit channel of monetary policy transmission. This article reviews the arguments of both sides in light of the current global financial crisis and economic downturn.
The rest of the paper is organised as follows: section 2 presents arguments in favour of the existence of operative credit channel of monetary policy transmission while section 3 presents the arguments of the opposing view. Section 4 analyses the linkages in light of the current financial crisis and concludes the paper.
2. The Credit Channel of the Monetary Policy Transmission: The
Proponents´ view
The study of the credit channel of monetary policy transmission also known as the credit view investigates the importance of bank lending in the propagation of exogenous shocks and the impact of this on the real economy. According to this view, a negative shock such as a monetary tightening, restricts the availability of credit to borrowers, thereby negatively affecting the real economy.
The "credit view" is an alternative to the conventional "money view" or the interest rate channel of monetary policy transmission.
According to [4] the credit view consists of two different views, namely (a) the bank-lending view and (b) the balance sheet view. The bank-lending view states that banks cut back on lending in the presence of tight money because they have less money to lend, even though there are good loans to be made. On the other hand, the balance sheet view implies that banks cut back on lending in the presence of tight money because borrowers are not in a good shape. The two views have different implications. However, both views imply that a monetary tightening reduces the supply of bank loans, thereby negatively affecting the real economy [4]. This transmission mechanism of monetary policy is called the credit channel.
The importance of the credit channel may depend on institutional characteristics of the financial market. For instance, according to [4] if banks can substitute from deposits to less reserve-intensive forms of finance, such as certificates of deposit, commercial paper, and equity, a reduction in bank reserves caused by a monetary tightening will not shift the supply curve of bank loans to the left. Similarly, if borrowers have access to a variety of non-bank financial sources, a leftward shift of the supply curve of bank loans, if any, will not affect the real economy. Thus economic literature suggests that the importance of the credit channel is likely to diminish over time due to ongoing financial innovation and deregulation [5].
However, according to [4], there may be institutional changes that make the credit channel of monetary policy more important. An example of such institutional changes may be the introduction of the risk-based capital standards in 1989 following the Basle Accord, in which the Bank for International Settlements (BIS) requires bank supervisors to impose minimum risk-weighted capital-to-asset ratios of eight per cent on all internationally operating banks of member countries. The BIS gives positive weights and zero weights to risky components (e.g. commercial and industrial loans), and safe components (e.g. U.S. government securities), of banks´ assets respectively. This means that banks can raise their risk-weighted capital-to-asset ratios by substituting from loans to government bonds. If several banks adjust their portfolios in this manner at the same time, the aggregate supply schedule of bank loans will shift to the left, and a credit crunch will ensue [4]. The reduction in supply of loans, then constraints firms dependent on bank loans from investing in the production of goods and services, thereby leading to economic contraction.
3. The Alternative View
According to [3] two fundamental problems make direct tests of the credit view difficult. These are (a) the difficulty of identifying exogenous monetary policy shocks, and (b) the difficulty of identifying the relationship between these shocks and subsequent real activity.
In order to mitigate this problem [3] used an indirect approach to test the credit view. First, they used changes in (stock) market expectations of Fed policy as the measure of policy shocks and identified them using daily accounts in the business press. Secondly, because the stock market reacts quickly to changes in expectations of future profitability, they observe near-contemporaneous responses of stock prices to policy shocks regardless of when in the future profits are expected to be altered. Thus, they mitigate the difficulty of identifying the effects of policy on real activity over time, by relying on the measure of investors' expectations of these effects.
They argue that if the credit channel is important, then firms that are dependent on bank credit and internal funds should receive a relatively greater benefit (loss) from a Fed easing (tightening) than firms with access to nonbank credit at favourable terms. They identify ten policy shocks during the expansion of 1993-94 and the "credit crunch" period of 1990-91 recession and find little evidence in support of an operative credit channel.
In addition to this [7] argues that in the presence of risk based capital requirements and an imperfect market for banks´ equity, there exists an alternative "bank capital channel" by which monetary policy can change the supply of bank loans through its impact on bank equity. This implies that monetary policy effects on bank lending depend on the capital adequacy and the profitability of the banking sector. Furthermore, lending by banks with low capital has a delayed and then amplified reaction to interest rate shocks, to well-capitalised banks.
The "bank capital channel" view extends the balance sheet view by incorporating the capital adequacy requirement and the existence of imperfect market for banks' equity.
4. The Credit Channel, Financial Crisis and Global Recession
Only empirical economic research will determine which channel of monetary policy transmission was responsible for the current global recession: the continued contraction in output and employment in all major industrialised countries. Whether it is the credit channel, bank capital channel or the financial accelerator, we are pretty sure that the invisible hand will not always produce visible outcomes. An adequate level of state intervention is crucial for the sustainability of capitalism, especially in financial sectors which are the life blood of the world economic system.
References
1]http://www.guardian.co.uk/business/2008/apr/09/useconomy.subprimecrisis (retrieved on 10/10/2008)
2]http://yalibnan.com/site/archives/2008/06/root_causes_of.php (retrieved on 10/10/2008)
3] Warner, E. and Georges, C. 2001. The Credit Channel of Monetary Policy Transmission: Evidence from Stock Returns., Oxford University Press.
4] Suzuki, T. 2002. Credit channel and risk-based capital adequacy requirements. Available at: http://dspace.anu.edu.au/handle/1885/40593
5] Bernanke, Ben S., and Mark Gertler. 1995. Inside the Black Box: The Credit Channel of Monetary Policy Transmission, Journal of Economic Perspectives, vol. 9, pp. 27-48.
6] Bernanke, Ben S., 2007. The Financial Accelerator and the Credit Channel. At the The Credit Channel of Monetary Policy in the Twenty-first Century Conference, Federal Reserve Bank of Atlanta, Atlanta, Georgia, June 15. Availably at
http://www.federalreserve.gov/newsevents/speech/Bernanke20070615a.htm
7. Heuvel S.J. 2007. The Bank Capital Channel of Monetary Policy. Department of Finance, The Wharton School, University of Pennsylvania.
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