Should banks Lend? Loan Supply vs. Loan Demand

While many are deriding the Treasury for its reluctance to force banks to lend capital allocated under the TARP program, it is not at all clear that bank lending is the proper way out of the crisis right now. The reason is that, without knowing the distribution of potentially high job losses and continued economic decline it would be foolish for consumers and businesses to borrow. But it would also be foolish in those circumstances for banks to lend. Hence, the economy is faced with the classic dilemma of whether current difficulties are due to loan supply or loan demand.

The relative emphasis of loan supply versus loan demand has been debated since the Great Depression, and there remains little agreement on the primary cause of business cycle persistence in during that period even today. In fact, the contributions of loan supply and loan demand to the Great Depression are still one of the great unknowns from that era.

The uncertainty about the relative effects of loan supply and loan demand puzzled economists even during the Great Depression. Classic studies, like that of Charles Hardy and Jacob Viner (Report on the Availability of Bank Credit in the Seventh Federal Reserve District. Washington, DC: US Government Printing Office, 1935) and that of Lewis Kimmel (The Availability of Bank Credit, 1933-1938. New York: National Industrial Conference Board, 1939) sought through surveys of banks and borrowers to add some understanding to the problem. Ultimately, however, while it was clear that banks were reluctant to lend, it was also clear that borrowers were reluctant to invest in new capital during such a time of great uncertainty.

Hence, today, it is not at all clear that we really want people to borrow to buy new cars when they could lose their jobs next month. Given memories of failed credit programs like Mitsubishi’s famous zero-zero-zero program, wherein they offered zero money down, zero payments for six months, and zero interest – and ultimately received zero money when the cars were repossessed, it is also not clear that such consumer borrowing would really help companies weather the crisis. We need to think hard about this classically unresolved conundrum before rushing headlong into $350 billion more in capital outlays.

In defense of Treasury on this one narrow point, it is not at all clear that we want Treasury or Congress directing this or other capital injections into the financial sector. Directed credit failures like that of Japan’s MITI or South Korean investment programs should be enough to dissuade policymakers from such exercises. Instead, what policymakers should have extracted in return for recapitalizations is a full, accurate, and complete disclosure of bank losses so those can be written off once and for all. Only after the losses are ascertained will prudent businesses and consumers alike move on and begin to invest and consume once again.

8 Responses to "Should banks Lend? Loan Supply vs. Loan Demand"

  1. interested reader   December 11, 2008 at 9:37 am

    That’s why the only solution is countercyclical public investment in public goods to make sure that the money is spent in a productive way. Future generations will have to co-pay but they will also have the benefits.

  2. Guest   December 11, 2008 at 11:01 am

    Why are banks not disclosing losses? Either the losses are more than we/our system can bear, or alternatively it’s less than we fear but they still want the government relief. Any thoughts?

  3. Michael   December 11, 2008 at 6:19 pm

    Excellent summary. There’s not much point in debating which comes first, the chicken or the egg, when both are dead. In stable times, if borrowing slows but there is eagerness (and sufficient capital) to loan, rates will drop until it is cost-effective to borrow with even high risk factored in; and if loaning slows but there is eagerness (and sufficient cash flow) to borrow, rates will rise until it is cost-effect to loan even with high risk factored in. The perfect storm occurs when, as Keynes put it “Those who are not creditworthy cannot secure a loan, and those who are creditworthy do not want a loan.” This is the moment when previous imbalances (the “credit bubble”) are self-correcting on a micro scale: each enterprise (lender or borrower) is reversing course from past risky practice, as it must to prevent its own insolvency, and when that pattern occurs across thousands of enterprises credit slows to a walk, a standstill, even a contraction.The only unresolved question I’m aware of is whether monetary and fiscal interventions by central bankers and politicians makes this cycle better or worse (with, of course, advocates for monetary vs. fiscal intervention and vice versa). The available information from the Great Depression, the Japanese deflation, and the current credit crisis – all of which have had substantial monetary and fiscal interventions – provides no substantiation that such a credit slowdown/standstill/contraction can be prevented or even lessened by intervention within a closed system. But there is evidence that if capital is suddenly injected from outside the system (e.g., beginnning in 1939 massive capital flows from Europe to America) the stuck credit loop can be unstuck. It’s hard to find any economy that is currently outside the current worldwide credit system that is contracting, which could play the Europe did for the U.S. heading into WWII – though there are people now fantasizing China could and would do so for us. Remember, it took the onset of a World War to motivate Europe to do so, and the outcome of that war was the economic destruction of Europe.

  4. Anonymous   December 19, 2008 at 8:19 am

    Why are banks not disclosing losses: because they do not know. Financial products are either too complex to be properly reported in internal IT systems, or assumption of losses depend on assumptions on values which are not easy to assess.If banks move energetically to improve reporting, that may lead them to realize that the prudential ratios are not abiden by and that they have no solution but chapter 11 (Us solution) or call the Ministry of Finance (European solution). Any result leading to the management being laid off. Management can hope last 6 or 12 months more, and in view of their incredible salaries, that makes a difference.

  5. VAHomeowner   December 19, 2008 at 8:56 am

    Do the banks really know what their true losses are? i.e this started with Real Estate so if we look at a home in CA that was originally worth $500k that is now worth $350k, is this now the true value for all homes in the same area for the banks portfolio?Would the bank have to write-down the value of all of their comparable loans? The same applies for Commercial RE values which we really haven’t heard too much about. Companies (think GGP) went out there, levered up, and took short time financing on commercial properties that they purchased. Asset values have decreased along with the revenue streams driving the value (tenant bankruptcies like CC, Linens n Things who no longer will pay rent). In today’s terms, the values of these assets have depreciated but the banks aren’t going to disclose this until absolutely necessary, i.e. at loan maturities or refinancing time. How could they? If they were to write down values (and take them as losses) today, they would risk over-stating their losses. I guess that a happy medium would be somewhere in between but I don’t think that the banks truly know what their losses are to provide full disclosure.