Monday, November 17, 2008

Paradox remains: bank lending flows in spite of credit crisis

The Wall Street Journal has a nice article today, Banks Keep Lending, but That Isn't Easing the Crisis . However, in spite of its interesting topic, the inherent paradox is not solved: credit markets are on red alert, but in spite of the four-alarm fire in the financial system, bank lending is flowing.
The chart (click to enlarge) illustrates the annual growth rate for weekly real estate, consumer, and commercial & industrial lending in 2008 as reported by the Federal Reserve. To be sure, lending has decelerated; but if anything it is reverting back to a historical average rather than contracting outright. In fact, on November 5, real estate lending grew at a 6% annual rate, commercial & industrial lending at a 15% annual rate, and consumer lending at a 10% annual rate.

The direction of bank lending (growing) is in direct contrast to the lending that should be (contracting) as implied by the state of the financial system.This is what the Wall Street Journal says (here are the relevant bits of the article, but if you want access to the full article, just send me an email) about the paradox:
“All around Washington, policy makers are scrambling to figure out how to get banks lending again. Lawmakers have criticized banks for not using new federal money to make loans and have threatened to place conditions on additional money. Regulators last week sent out a directive, encouraging banks not to hold back on lending.

But there's a flaw in that logic. Banks actually are lending at record levels. Their commercial and industrial loans, at $1.6 trillion in early November, were up 15% from a year earlier and grew at a 25% annual rate during the past three months, according to weekly Federal Reserve data. Home-equity loans, at $578 billion, were up 21% from a year ago and grew at a 48% annual rate in three months.

The numbers point to one of the great challenges of the crisis. The credit crunch is surely real, but it is complex and not easily managed. Banks are lending, but they're also under serious strain as they act as backstops to a larger problem -- the breakdown of securities markets."
And a little later in the article…
"A new paper by Harvard Business School economists David Scharfstein and Victoria Ivashina sheds light on how the recent rise in bank lending plays into this. Bank loans are rising, the economists say, because companies -- from General Motors to Tribune -- have turned to banks for precautionary cash. With markets shut down, they're drawing on existing credit lines to meet financing needs or simply to have money in reserve in case they need it later.

Many of these firms lined up credit facilities during the boom, when terms on loans were forgiving. Between April 2006 and April 2008, bank rainy-day credit lines, known as revolving credit facilities, increased by 36% to $3.5 trillion, the professors show. Individuals might be using home-equity lines in the same way, tapping them for cash while the lines are still open.

The point is that banks are being forced to act as backstops to a reeling financial system just as the banks, too, are vulnerable. Simply demanding they lend more misses the broader point of the role they're playing in the crisis, and how to manage it.

"They provide a measure of protection to vulnerable firms, helping them forestall financial distress," the Harvard professors argue. But there is a dangerous downside. During the boom, many of these credit lines were extended to firms with shaky prospects, like GM. Now, banks are on the hook to lend to them, often even if they don't want to. This is likely crowding out making new loans to healthier firms, the professors say.

Crowding out is one problem. Another is the markets. During the boom, many bank loans were packaged into securities. With markets for those securities shut down, banks have lost this important escape valve for making new loans."
Rebecca here. This article concurs what I have said all along. Bank lending is flowing, but households and firms are drawing on already existing lines of credit.

Now I have not read the Scharfstein and Ivashina paper, but the WSJ implies that Scharfstein and Ivashina do not actually solve the paradox, bank lending is flowing in spite of a credit crisis in the financial system. Scharfstein and Ivashina (via the WSJ article) simply suggest that banks are crowding out new lending, i.e., the drawing on already existing lines of credit are reducing the availability of new business lending. The implication is the following: had the existing lines of credit not been in place, there would be new lending. The paradox has not been solved.

I still find it terribly interesting that lending is flowing at all, and further, that it would be had the existing lines of credit not been available (which is what Scharfstein and Ivashina suggest). The simple explanation is that the Fed and the Treasury plans are somehow working – the new $250 billion in capital and the $1.2+ trillion in new liquidity – by preventing bank lending from contracting...well, at least sort of, partially.

I see many academic papers of the horizon: solving the credit/lending paradox.

Rebecca Wilder

4 comments:

  1. http://www.bos.frb.org/bankinfo/qau/wp/2008/qau0805.pdf

    ReplyDelete
  2. http://www.newsneconomics.com/2008/11/paradox-remains-bank-lending-flows-in.html

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  3. Now I have not read the Scharfstein and Ivashina paper, but the WSJ implies that Scharfstein and Ivashina do not actually solve the paradox, bank lending is flowing in spite of a credit crisis in the financial system. 

    ReplyDelete
  4. They provide a measure of protection to vulnerable firms, helping them forestall financial distress, the Harvard professors argue. But there is a dangerous downside.

    ReplyDelete