The Financial Crisis and the Bank Lending Channel of Monetary Policy Transmission

M. Shahidul Islam and Ramkishen S. Rajan

Bank lending is an important but oft-neglected channel via which monetary policy affects the overall economy. A large number of firms depend on commercial banks for funding, particularly small and medium sized enterprises (SMEs). The basic idea behind the bank lending channel is as follows: an expansionary monetary policy raises the excess reserves of banks, leading to lower bank lending rates, hence increasing bank lending and economic activity. The bank lending channel, which ordinarily works quite effectively during normal circumstances, can breakdown during times of financial stress, as appears to have been the case in the ongoing global financial crisis.

            How the bank lending channel works and why it may fail

At a broad conceptual level the basic bank lending channel during an expansionary monetary policy phase is as follows. The greater liquidity from the central bank at lower costs in turn increases the supply of bank credit, leading to a fall in bank lending rates and a consequent rise in the quantity of bank lending. However, during a situation of bank distress, infusions of liquidity into the banking system may not readily translate into a rise in bank lending as banks become highly risk averse — especially in the face of growing nonperforming loans (NPLs) and eroding capital bases (“capital crunch”) — and choose instead to hoard funds. This in turn implies no change in bank lending rates or the quantity of bank lending.

It is, of course, possible that due to moral suasion from the central bank or for some other reason, banks may feel obliged to lower lending rates. However, if this is the case, they could still choose to restrict lending. While some might interpret this situation as one of disequilibrium, i.e. mandated ceiling interest rate, causing an excess demand over supply, from a bank’s perspective, they may view effective demand as having declined as there are fewer creditworthy customers who would qualify for bank loans.

This is a situation where monetary policy transmission breaks-down in the sense that central bank-infused liquidity into the banking system does not find its way to the rest of the economy; credit is clogged up in the banks. This is the classic credit crunch where the problem is not so much the cost of funds but the availability of funds and there is an endless debate about whether the lack of credit creation is because banks are not lending or there are not enough “credit-worthy” customers as perceived by the banks. The relevant point here, however, is that increases in reserve money without any corresponding expansion of broad money will show up as a decline in broad money multiplier — the ratio of broad money to base money.

 

            Bank lending story in the US

In the case of the US, as part of the monetary easing programme in response to the crisis, the Fed funds rate has been cut to its lower bound (setting a target between 0 and 0.25 percent) and the bank prime loan rate in the US subsequently declined in line with the Fed rate cut. However, there was a sharp rise in the LIBOR-OIS spread (a measure of the degree of risk aversion of banks) in September-October 2008. Given this risk aversion, banks were not extending credit to the public, choosing instead to hoard reserves or place them in government securities, consequently leading to a drop in the money multiplier.

More precisely, thanks to massive credit easing programme the monetary base (M0) in the US more than doubled from US$ 843 billion in August 2008 to US$ 1.75 trillion in May 2009. However, broad money growth did not increase at the same pace. As a result, the money multiplier collapsed from 9.1 in August 2008 to 4.7 in April 2009 and the gigantic increase in Fed balance sheet has not translated into credit growth as banks chose to hold the excess reserves rather than make loans to the private sector. (It also suggests that the inflation concerns were over-played initially as broad monetary growth did not blow up unlike narrow money.)

            Bank lending story in India

The global financial crisis hit India initially via the financial channels, particularly following the collapse of the Lehman Brothers in September 2008 and consequent global deleveraging. Many Indian corporates that had depended on global wholesale markets for “cheap” foreign currency funding suddenly found themselves facing a major liquidity crisis as credit dried up as concern about counterparty risks sky-rocketed. As these entities turned to domestic banks and nonbanks (such as mutual fund withdrawals) to refinance so as to remain liquid, there were huge pressures on domestic sources of liquidity.

In the case of the banking sector these pressures were reflected most obviously in the sharp rise in volatilities in the India call money market. The wealth destruction in India and globally due to asset price declines as well as the increased cost of credit inevitably caused the country’s export growth to plunge and industrial production to decelerate in August-November 2008.As the gravity of the financial crisis became apparent, and from mid September-October 2008, the RBI took several policy measures to ease both the rupee and the foreign exchange liquidity conditions in the financial system. The RBI reduced the key policy rates (the repo and the reverse repo), while the Cash reserve requirement (CRR) was cut sharply and other measures were taken to ease domestic liquidity sharply. Foreign exchange liquidity was also eased by loosening restrictions on external commercial borrowings (ECBs) and short-term trade credits, while interest rate ceilings on nonresident deposits were raised in order to attract more foreign funds into the country.

How did these monetary measures affect the growth of reserve money, broad money and non food credit? Since June 2008 the growth of reserve money has declined sharply (year-on-year) until March 2009. The two main reasons for this deceleration was the decline in net foreign assets (NFA) due to a loss of foreign exchange reserves, and more importantly, the decline in the CRR, which implied lower net domestic assets (NDAs) due to a fall in bank reserves with the RBI. Infusions of liquidity by the RBI helped to offset partially some of these declines. More importantly for the economy is that fact that credit and broad money continued to grow at a stable and robust rate. The decline in reserve money and consequent increase in broad money inevitably implied a sharp rise in the money multiplier, in sharp contrast to the US, as discussed above. The fact that credit was rising robustly implies that there was no significant credit crunch in India during the period under consideration.

To further emphasise this point one can also look at the broad picture of credit by examining trends in the ratios of monetary and credit to the industrial production index (IPI). neither the M3-to-IPI nor credit-to-IPI ratios dropped below their past trends and have in fact increased marginally. Hence, contrary to prevailing perceptions, analysis based on different indicators shows that monetary and credit growth in India have been maintained at their historic growth trends even in the midst of severe global economic crisis.

Bank lending conundrum in India

Overall, the monetary actions clearly eased the liquidity crunch in India. The added liquidity has partly offset the drying-up of nonbank sources of funds. But despite the seeming success of RBI’s policy interventions to offset any potential credit crunch, surprisingly bank lending rate has not declined in line with the RBI’s credit easing policies. The repo rate has declined sharply but the prime lending rate has not fallen at the same pace, with the result that the spread between the two rates remains high.

Conceptually, one can reconcile these seemingly contradictory facts, viz. robust lending but downward rigidity in lending rates, if one believes that the increase in supply of loans was also matched by an increase in demand, such that overall lending grows but there is little or no change in lending rates. As noted, in the case of India, there was a significant rise in demand for funds domestically as many corporate shifted from overseas borrowing (which had dried up) to domestic sources, including banks. In addition, there are some structural issues concerning further downward adjustments in benchmark prime lending rates (BPLR) as they are linked to the rate of inflation and deposit rates. In addition, the bulk of banks’ time deposits continue to be at fixed interest rates. Banks may, therefore, need some time to re-price their loans.

Apart from structural problems that hinder the reduction of the BPLR, the other issue has to do with effectiveness of moral suasion. The RBI has been able to influence the public sector banks — that accounted for over 70 percent loan growth in 2008-09 — to reduce BPLR and increase the credit flows, but private and foreign commercial banks have been rather reluctant or slow to respond to such calls. The private sector and foreign commercial banks showed clear conservatism, both in terms of increasing credit flows to the private sector in March 2008-09. Private and foreign banks appear to have chosen to park some of the excess liquidity at the RBI’s reverse repo window and investing in government securities rather than lend out.

Overall, India does not appear to have faced a severe domestic credit crunch as experienced in the US and elsehwhere. This in turn may have been because of the fact that the Indian banking sector is largely controlled by the public sector banks (in terms of total assets, deposits and advances). These public banks have been quite responsive to the RBI’s moral suasion and other credit easing measures. This may have lessons for further liberalization of India’s banking sector going forward, though these possible macro stability gains must be traded-off against possible microeconomic benefits from greater private sector competition.

M. Shahidul Islam is a Research Associate at the Institute of South Asian Studies (ISAS), an autonomous research institute at the National University of Singapore. He can be contacted at [email protected] Ramkishen S. Rajan is a Visiting Senior Research Fellow at ISAS and an Associate Professor at George Mason University, Virginia, United States. He can be contacted at [email protected] or [email protected] This op-ed is based on a longer working paper by the authors. See http://www.isasnus.org/events/workingpapers/78.pdf .