Panel Discussion: "The Real Effects of Disrupted Credit:
Evidence from the Global Financial Crisis"
Per Jacobsson Lecture by Ben S. Bernanke
BIS, Sunday, 24 June 2018
Remarks by Ignazio Visco, Governor, Bank of Italy
I am very pleased to be here today to discuss the economic effects of credit
crunches with such a distinguished group of colleagues and friends following Ben
Bernanke's insightful lecture.
The time is ripe to draw some policy lessons about the exceptional wave
of turbulence that has hit credit markets in the last decade. I shall do so from
a European angle. The European banking system has endured two major crises
in the past decade: the Global Financial Crisis (GFC) and the Sovereign Debt
Crisis (SDC). The former was mostly imported from the United States and it hit
European banks through their exposure to toxic assets and the freeze of wholesale
funding markets. The latter originated within the euro area and was due to a loss
of confidence in the sustainability of public debts and, ultimately, to the risk of a
break-up of the monetary union.
In my remarks I will focus on the negative side of Ben's financial accelerator,
that is, on the fact that in stressed periods banks may not be able to supply loans
to businesses and consumers and this may aggravate the economic fall-out from
the crisis, triggering a downward negative spiral between credit availability and
domestic demand.1 I would like to make six main points.
* * *
1. Credit crunches do matter and may arise in many contexts
The first lesson is that credit crunches do matter and that they may arise in
many contexts.
Credit supply reacts negatively to adverse shocks generated in the real or the
financial sector, amplifying the decrease in real activity; the ensuing contraction
in credit demand and the deterioration in credit quality puts further pressure on
banks' balance sheets and reinforces financial strains, creating a vicious circle.
The experience of the euro area since 2007 offers a painful vantage point from
which to appreciate the extent of this downward loop, which partly explained the
fall in GDP during both the GFC and the SDC.
The GFC spread over Europe in two forms: a real shock, due to the collapse of
world trade and the surge in uncertainty, and a purely financial shock, via exposure
to toxic assets and the freeze of wholesale bank funding markets. Both channels
affected bank lending standards in the euro area (Figure 1). During the GFC most
of the tightening of credit conditions was connected with banks' assessment of
borrowers' credit risk, probably owing to the real shock. However, another factor
was banks' greater funding costs and other balance sheet constraints. The case of
Italy is enlightening. First, since the worse international outlook accounted for
roughly three quarters of Italy's economic slump, the contraction in credit lines to
firms came mainly from the deterioration in borrowers' creditworthiness.2 Second,
Italy's financial institutions were not exposed to toxic assets, so balance sheet
constraints were less of an issue than in the rest of the euro area. Yet, financial
shocks did matter, too: as bank surveys also signalled, the GFC caused a freeze in the
interbank market that weakened banks' funding conditions, leading to a contraction
in credit lines to firms.3 The consequent worsening of firms' financing opportunities
discouraged their investment plans, thus affecting credit demand and activating the
financial accelerator. The Bank of Italy's estimates put the reduction in investment
expenditure by firms in Italy due exclusively to this channel at over 20%.4
Compared with the GFC, the SDC was triggered by different shocks.
It stemmed from growing concerns about country-specific structural weaknesses,
aggravated by the recent GFC, and became systemic because of growing concerns
about the solidity of the monetary union, which led financial market participants to
price in redenomination risk. The increase in sovereign spreads worsened funding
conditions for all domestic borrowers, from banks to non-financial corporations and
households. Following, moreover, the increase in uncertainty, the loss of confidence
and the necessary fiscal consolidation as well, consumption and investment
diminished.5 This re-activated the financial accelerator.6 Unlike the GFC, the
tightening of banks' lending standards was to a larger extent due to the deterioration
in their funding conditions rather than to the rise in borrowers' credit risk.
2. The nexus between the solvency of banks and that of the domestic
sovereign goes beyond banks' mere holdings of government bonds
This leads me to the second lesson, which concerns the sovereign-banks nexus.
In a sovereign debt crisis the holdings of government bonds backfire directly onto
banks' valuations, but there are other indirect channels that characterize the two-way
relationship between banks and State.
A cursory look at banks' balance sheets reveals that up to the failure of Lehman
Brothers in September 2008 euro-area banks had been steadily reducing their
holdings of government bonds.7 That share then increased during the prolonged
period of financial instability running from late 2008 to early 2013. Since then,
in most euro-area countries banks' government bond holdings have edged down
again. Thus, the increase in banks' holdings of government bonds during the crisis
was mainly a consequence, rather than a cause, of the crisis (Figure 2).
The SDC worsened the general macroeconomic outlook and this put banks
under severe strain. For this reason, as I have pointed out in the past, the nexus
between banks and sovereign goes beyond the direct holdings of sovereign bonds.8
Accordingly, it has to be tackled by reinforcing investors' confidence in the solidity
of the public finances, the growth prospects of the country and the stability of the
banking system.
As an aside, I would say that the increase in banks' sovereign exposure
observed during the crisis should not necessarily be regarded as problematic.9
In the face of greater funding risks, banks need to hold more liquid assets.
Moreover, in stressed periods banks could have an incentive to act as shock
absorbers or contrarian investors on the domestic government bond market for a
number of reasons. Specifically, they may want to dampen unwarranted changes in
government bond prices, as the latter feed through to the prices of all other domestic
assets. Compared with foreign players, they may have a better understanding
of political and economic developments in their own country. They know that
they are closely intertwined with their sovereign through funding conditions, the
macroeconomic environment and other indirect channels, so that if their sovereign
runs into trouble, they will probably run into trouble as well, no matter how many
domestic government bonds they hold.
3. Thestructureofthefinancialsystemdoesmatter
My third point concerns the importance that firms rely upon a well-diversified
system of funding sources. The two crises propagated differently across countries
depending not only on macroeconomic conditions but also on the structure of
the financial system. There is evidence that, during recessions, economies with
market-based financial systems recover more quickly than those that rely mainly
on banks.10 This is especially true if the recession goes hand in hand with a financial
crisis. More diversified financial systems also matter for growth, as they expand
the financing tools available to borrowers and improve investors' portfolio choices
and risk management techniques.
Greater resilience is also likely to come with higher solvency. This suggests
that not only does diversification insulate firms from credit crunches, it also benefits
banks, to the extent that it leads to lower credit risk and lower non-performing
loans (NPLs), and the whole system as well, as healthier banks are more likely to
provide credit.
In general, market-based finance is more prominent in the United States than
in Europe and, within Europe, in the UK and France (Figure 3). Over the last ten
years, however, the funding structure of the non-financial corporate sector in the
advanced economies has changed significantly. Partly as a result of the weakening
of bank lending observed during the two crises, there has been a generalized
increase both in equity as a share of total liabilities and in debt securities as a share
of total debt. The greater role of equity and bond financing in Europe is a welcome
development. Nevertheless, important differences continue to be observed across
countries and across firms of different sizes, as small and medium-sized firms are
still heavily dependent on bank credit. Improving access to capital markets for
all firms, regardless of their size, is an objective to aim for in the near future with
appropriate structural policies, including the capital markets union programme.
4. There is no automatic connection between well-provisioned NPLs,
the supply of credit and resource misallocation
My fourth point is about the relationship between ailing firms, non-performing
loans and credit supply.
Two deep recessions in the space of a few years have naturally increased the
number of ailing firms, bringing about a sharp rise in the share of non-performing
loans. Italy's experience is fairly instructive in this respect: the ratio of new bad
debts to outstanding loans to non-financial firms almost tripled during the GFC and
then continued to grow, peaking during the SDC.
Against this background, a first concern is that of credit misallocation, which
arises if banks continue to lend to weak firms in order to delay recognizing losses
on their credit portfolios. Studies carried out for Italy have shown that some
misallocation did take place during the crises, but it involved predominantly small
and less capitalized banks and it had negligible effects on the growth of healthier
firms and total factor productivity dispersion.11
A second concern is that high NPLs hamper banks' ability to supply credit
to the economy (Figure 4). Certainly, the emergence of new NPLs has negative
effects on banks' ability to lend, but these are mostly indirect, via a higher cost
of funding, lower profitability and eroded capital.12 However, this does not imply
that stocks also play a role. There is no clear empirical evidence - or theoretical
support - that a high stock of NPLs per se directly reduces banks' ability to lend.
Furthermore, a fair share of NPLs granted to ailing (but not yet bankrupt) firms
return to performing status after a while.13
Thus, while the negative effects of NPLs on capital and profitability justify the
current policy action in favour of NPL reduction, forcing banks to dispose quickly
of such positions could be counterproductive. Large disposals of NPLs at market
prices that are much lower than book values would generate losses sizeable enough
to offset the benefits to the bank in terms of improved asset quality. Ultimately,
blanket disposals could hamper banks' ability to lend, with negative spill-overs on
the overall economy.
5. Financial integration is a key aspect of functioning credit markets
The fifth lesson is about the importance of fostering economic and financial
integration.
Another particular feature of the bank lending crunch in the euro area was the
considerable increase in financial fragmentation across countries (Figure 5), which
contributed to the reduction in economic activity and posed a substantial challenge
to the correct transmission of the monetary stimulus. The institutional set-up of the
monetary union was caught off guard and fell short of the needs generated by the
two financial crises, compounding the centrifugal forces arising from deteriorating
economic fundamentals. It is thus of key importance that we continue boldly to
support and reinforce the process of financial integration.
On a brighter note, the experience of the SDC has proved that global financial
integration can be an effective shock absorber. It has now been documented that
foreign banks can act as stabilizers in credit markets that are under stress.14 In
a way, foreign intermediation can be viewed as a global insurance scheme that
swiftly takes liquidity where it is most needed. Naturally, we have to ensure that
these dynamics do not bring instability, which we can and should do through
regulation. Yet, when integration is properly regulated, its benefits largely exceed
its costs.
6. Central banks have used many tools to support credit supply,
including credit easing
The sixth and last lesson that I draw is that we now have a better understanding
of how to avert or mitigate credit crunches.
The response of the ECB was swift, and it extended well beyond the trough of
the crises to accompany the recovery and accomplish its price stability mandate. A
number of extraordinary measures were put in place almost simultaneously: two
waves of TLTROs were implemented, key interest rates were taken into negative
territory and steered ahead through forward guidance, and the APP was launched
(Figure 6).
The TLTROs were designed to provide banks with funds "targeted" to expand
credit to firms and consumers.15 With about €760 billion allocated, the initiative,
which ended in March 2017, witnessed ample participation and was pretty
successful: the rates on loans to non-financial corporations declined markedly and
stayed low; in addition, a positive impact can be detected on volumes of business
as well.16 Evidence drawn from the euro-area Bank Lending Survey confirms these
conclusions, which are also corroborated by a recent empirical study carried out
at the Bank of Italy, documenting that banks participating in TLTROs apply an
interest rate to the same firm 20 basis points lower than non-participating Italian
banks.17
Research on the other measures is still ongoing, but the available evidence
suggests that their effects have been largely positive.18
All in all, today we can say that the ECB's intervention has also been effective.
This has also been acknowledged by euro-area financial intermediaries, which,
in their answers to the euro-area Bank Lending Survey, reported a direct positive
impact of these measures on both volumes of business and the costs applied to
borrowers.
* * *
Summing up, my main focus has been the real effects of the disruption of
credit markets in the euro area and related policy lessons.
The overall impact of credit disruption on the real economy is the result of a
hardly discernible ex ante, yet vicious ex post, loop between bank lending and the
real sector in difficult times. In fact, a contraction in credit supply can leave the
real sector in a state of vulnerability that may in turn have adverse effects on the
financial sector. This harmful negative feedback takes place in a variety of forms, in
terms of weakness of borrowers' demand for credit, circumspection of investment
plans and the general uncertainty that keeps all economic actors, including banks,
from "acting normally". This situation, especially if prolonged, weakens banks'
balance sheets and reduces their resilience to unexpected events, which may result
in a second round of credit restrictions.
Looking at the experience of the euro area, both the GFC and the SDC have
demonstrated the importance of these feedback effects from the real economy to
the financial system: the last decade has arguably seen these feedbacks turned
into a "fact" to be confronted rather than a "possibility", and hence into a key
challenge for policy action. It is of vital importance that the strengthening of the
financial sector does not create negative spin-offs for growth: if it does, it risks
taking both the financial and the real economy farther from, rather than closer to,
a full recovery.
On a brighter note, we have learnt a lesson during these years, and today
we stand better prepared to withstand future, unavoidable turbulences. The
unconventional policy measures that we have deployed in this decade are now part
of the central banks' "emergency" toolkit. Some of them, such as the TLTROs, are
there to be re-activated in times of need while others, such as forward guidance,
will accompany us in our daily conduct of monetary policy.
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FIGURES
Figure 1
Changes in credit standards to firms: contributing factors
(diffusion index; tightening(+)/easing(-))
Source: ECB (Bank Lending Survey) and Bank of Italy calculations.
Figure 2
Banks' holdings of domestic government bonds in the euro area
(as a percentage of total assets; monthly data)
Figure 3
Diversification of corporate funding sources
(a) Non-financial corporations: equity (b) Non-financial corporations: debt securities
as a share of total liabilities as a share of total financial debt
(per cent) (per cent)
Source: Eurostat and Federal Reserve System data and Bank of Italy calculations.
Figure 4
Non-performing loans and bank lending in Italy
(a) NPL flows and difficulty of accessing credit (b) Share of NPLs over outstanding loans and
by non-financial firms (1) (2) growth rate of bank lending (1)
(per cent; diffusion index) (per cent)
Source: Angelini (2018)
(1) Data for 2017 are provisional. - (2) The indicator of difficulty of accessing bank credit is taken from ISTAT.
Figure 5
Cross-country dispersion of the cost of loans to non-financial
corporations in the euro area
(diffusion index; tightening(+)/easing(-))
Source: ECB. The cost of loans is the ECB composite cost-of-borrowing indicators, based on MFI interest
rate statistics. Dispersion is computed as the standard deviation of the average interest rates for 12 euro-area
countries.
Figure 6
Euro-area banks' perceived impact of ECB measures on bank lending
(diffusion index; tightening(+)/easing(-))
(a) TLTRO: impact on terms and conditions (b) APP: impact on terms and conditions
Source: ECB (Bank Lending Survey) and Bank of Italy calculations. Credit terms and conditions refer to
the conditions of a loan that a bank is willing to grant. They generally consist of the agreed spread over the
relevant reference rate, the size of the loan, the access conditions and other terms and conditions in the
form of non-interest rate charges (i.e. fees), collateral or guarantees which the respective borrower needs to
provide (including compensating balances), loan covenants and the agreed loan maturity.
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