Bank Lending: Too Much of a Good Thing?

Global banks do not have much to cheer about these daysEarnings are falling, and the banks are responding by cutting jobs. The Federal Deposit Insurance Corporation has charged 16 banks of colluding to rig the London Interbank Offer rate (LIBOR). And theFederal Reserve has approved a rule that requires foreign banks with $50 billion of assets in the U.S. to establish holding companies for their American units that meet the same capital adequacy standards as do their U.S. peers. The latter move has been interpreted as a sign of the fragmentation of global finance that will hinder the global allocation of credit.

The Federal Reserve supported the foreign banks in the fall of 2008 when the it lent to distressed institutions. The U.S. units of European banks accounted for $538 billion of the Federal Reserve’s emergency loans, over half of the total. Federal Reserve Chair Ben Bernanke had to answer criticism from U.S. lawmakers that the loans did not benefit U.S. taxpayers. At the same time, the Federal Reserve was establishing swap lines with central banks in 14 countries. The dollars those monetary authorities acquired were used to prop up their banks that needed to finance their holding of U.S. debt.

Banks have various ways to meet the new capital adequacy standards. They can hold back on dividend payouts from their earnings, although that may not be popular with their stockholders. They can raise funds in the capital markets. And some banks, such as Deutsche Bank, will shrink their balance sheets in order to comply with the regulations. This has led to fears of cutbacks in lending.

The announcement of the new standard came as the Bank of International Settlements (BIS) was publishing its quarterly report on the international banking markets. The BIS data showed that the cross-border claims of BIS reporting banks fell by $500 billion in the their quarter of 2013, the biggest contraction since the second quarter of 2012. Most of this decline occurred in Europe, as lending between parents banks and their subsidiaries in the Eurozone and the United Kingdom declined.

Would a contraction in bank credit have negative consequences? It certainly will for those firms in Europe that are unable to obtain credit. But there are also grounds for believing that a reduction in banking activity may under some circumstances be advantageous for an economy. The same issue of the BIS Quarterly Review that reported the international banking data also carried an article by BIS economists Leonardo Gambacorta, Jung Yang and Kostas Tsataronis. They compared the impact of bank and capital market activity on economic growth, and found that increases in both contributed to higher growth, but only up to threshold levels of GDP. After those thresholds are reached, further expansion in banking or capital markets had negative impacts on growth. Similar results have been reported by Jean-Louis Arcand, Enrico Berkes and Ugo Panizza of the IMFStephen G. Cecchetti and Enisse Kharroubi also at the BIS, and Sioong Hook Law of Universiti Putra Malaysia and Nirvikar Sinth of UC-Santa Cruz in the Journal of Banking & Finance (working paper version here).

These studies deal with the domestic impacts of financial activity. How about bank lending across borders? The record there also demonstrates that bank lending can have adverse consequences. Martin Feldkircher of Oesterreichische Nationalbank (the National Bank of Austria) has a paper in the Journal of International Money and Finance (working paper version here) that examines the determinants of the severity of the global financial crisis in 63 countries, using 97 candidate variables. He reports that the change in domestic credit provided by the banking sector is a robust determinant of crisis severity. When he further investigated by interacting the bank credit variable with measures of risk, including macro, external, fiscal, financial and contagion and spillover risk, he found that the interaction of bank credit with foreign claims from banks in advanced countries robustly explained crisis severity. He concludes: “Countries with high credit growth and considerable exposure to external funding saw their economies more severely affected during times of financial distress.”

There is a line between financing new economic activities and bankrolling speculation. The former promotes welfare, the latter ends in volatility and distress. Unfortunately, that line shifts as new opportunities appear. Trying to find it is a constant challenge for regulators.

This piece is cross-posted from Capital Ebbs and Flows with permission.

One Response to "Bank Lending: Too Much of a Good Thing?"

  1. Don   March 18, 2014 at 1:09 pm

    We have too little Regulation for the risk posed.