2018 - Unclogging the credit channel

On November 12-13, De Nederlandsche Bank organized its 21st Annual Research Conference. This year the conference theme was “Unclogging the Credit Channel”. The aim of the conference was to discuss the link between monetary policy, bank lending, and the real economy. The program featured two keynote speeches by Simon Gilchrist and Atif Mian, eight paper presentations and a policy panel. 

In his keynote speech Simon Gilchrist (New York University) analyzed the economic consequences of forming a monetary union among countries whose financial markets are subject to varying degrees of distortions. Due to customer-market considerations financial shocks affect firms’ pricing decisions, influencing markups and market shares across countries. When applied to the eurozone crisis, the interaction of customer markets and financial frictions explains several phenomena that conventional models cannot reconcile. First, the pricing mechanism is consistent with empirical facts. Specifically, the evidence suggests that the tightening of financial conditions in the euro area periphery between 2008 and 2013 weakened the downward pressure on prices due to the emergence of substantial and long-lasting economic slack. Second, the tightening is strongly associated with an increase in price markups in the periphery. This framework can explain why periphery countries managed to avoid debt-deflation in the face of persistent economic slack and how the “price war” between the core and periphery has impeded the adjustment process through which the latter economies tried to regain competitiveness.

Atif Mian (Princeton University) discussed in his keynote speech the role of credit expansions and agents’ beliefs in the formation of housing bubbles and financial cycles. He presented empirical evidence showing that U.S. zip codes more exposed to the 2003 acceleration of the private label mortgage (PLS) securitization market witnessed a sudden and large increase in mortgage origination and house prices from 2003 to 2006, followed by a collapse in house prices during 2006-2010. During the boom, cities with higher PLS-market exposure were more likely to see a large increase in house prices despite a substantial new construction; these cities experienced a severe bust after 2006. Mian pointed out that most of the marginal home-buyers brought into the housing market by the acceleration of the PLS market were short-term buyers or “flippers”. These marginal buyers had lower credit scores and higher ex post default rates. Speculation by such home-buyers contributed to a large rise in transaction volumes during 2003-2006 and to the onset of the mortgage default crisis in 2007. 

The policy panel discussion focused on the changing nature of the credit process and its implications. Simon Gilchrist talked about measures of financial distress that can predict future economic activity. He stressed that there is a weak relationship between economic activity and inflation which poses challenges for monetary policy. Next, Atif Mian discussed trends and cycles in credit growth since the 1980s. He drew attention to secular trends in global economy which might be driving the global credit cycle and emphasized the role of macroprudential policy in controlling credit cycles. Finally, Leonardo Gambacorta (BIS) described technological innovation as an important factor for the evolving credit channel. He discussed the growth of FinTech and BigTech firms and their possible impact on resource allocation and financial intermediation. He pointed out that the financial stability implications of FinTech still need to be understood and that the evaluation should be done over a complete financial cycle.

Presented papers studied various aspects related to the credit channel of monetary policy. Oliver De Groot (ECB) analyzed whether the transmission of monetary policy differs in times when the policy rate is at the effective lower bound. He explored a signaling channel through which negative interest rates on reserves can be expansionary, even when deposit rates are bounded by zero. Despite lower interest on reserves resulting in a fall in bank net worth, the cut into negative territory signals that deposit rates will remain lower for longer, boosting economic activity and inflation.

Sarah Holton (ECB) argued that bank heterogeneity could affect both credit demand and supply. Using novel bank-specific survey data matched with balance sheet information on euro area banks, she presented evidence that following a conventional monetary policy shock, bank balance sheet strength influences not only credit supply but also credit demand. In addition, borrowers demand less credit from banks with weaker balance sheets, while banks more exposed to non-standard monetary policy measures increase credit supply.

Isabelle Roland (University of Oxford) examined whether weak productivity growth since the global financial crisis can be attributed to financial factors. She used firm-level data to estimate aggregate losses from credit frictions. The analysis showed that ex ante default assessments matter for capital allocation and that credit frictions depress output. Losses have been increasing since the great recession and are driven primarily by lower aggregate capital and not by misallocation of credit across heterogeneous firms. These losses are mainly due to frictions on SME credit markets.

Falk Mezelis (ECB) studied how the regulation of shadow banking affects an economy at the ZLB, based on the estimation of a DSGE model with funding market frictions. He found that regulating shadow banks like investment funds results both in a milder recession and in a quicker recovery from ZLB episodes. This is because a recessionary demand shock that moves the economy to the ZLB has similar effects to a monetary tightening due to the inability to reduce the policy rate below zero.

Magdalena Rola-Janicka (University of Amsterdam) proposed a theory of crises based on rational expectations where the key frictions leading to the build-up of risk and to the crisis include limited liability, deposit insurance, and imperfect information. Recessions are often accompanied by an increase in corporate default and prolonged declines in business credit.

Wei Cui (University College London) presented a theory showing that credit and default cycles can result from variations in self-fulfilling beliefs about credit market conditions. In his model credit contracts reflect the expected default risk of borrowing firms. Self-fulfilling changes in credit market expectations generate sizable reactions in default rates together with endogenously persistent credit and output cycles, accounting for most of the corporate default volatility and over 20% of output volatility.

Saleem Bahaj (Bank of England) examined whether it is always the case that tighter capital requirements reduce bank lending as suggested by common wisdom. On the contrary, he showed that a bank may optimally respond to a higher capital requirement by increasing lending. This requires that the marginal loan generates positive residual cashflows in the states of the world where the bank just defaults. Since an increase in the capital requirement makes the bank safer, it makes the shareholders internalize such cash flows. He argued that this mechanism is empirically relevant.

Sebastiaan Pool (DNB) discussed the effect of government recapitalizations aimed at restoring banks’ ability to repay deposits after a crisis. He examined two types of recapitalizations: immediate and delayed. In the steady state, both policies cause the banking sector to charge inefficiently low lending rates, leading to an inefficiently large capital stock. Raising bank equity requirements reduces this inefficiency. A delay in recapitalizations creates banking sector debt-overhang, which leads to inefficiently high lending rates, reduces credit supply and weakens the monetary policy transmission.

More information on the program, papers and presentations is available on the conference website.