metadata: authors: 0: author: Caprio,Gerard
1: author: Honohan, Patrick
docna: 0: docna: Banking policy and macroeconomic stability -
            an exploration
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Industrial Economics,Legal Institutions of the Market Economy,Economic Growth,Economic Stabilization,Deposit Insurance,Financial Sector Policy
teratopic: Finance and Financial Sector Development
abstracts: cdata!: Whether and when does banking serve to
            stabilize the economy? The authors view the banking system
            as a filter through which foreign and domestic shocks feed
            through to the domestic economy. The filter can dampen or
            amplify the shocks through various credit market channels,
            including credit growth, import of foreign capital, and
            possibly interest rates. The question is whether the
            prudential quality of banking, as proxied by measures of
            regulatory quality and openness to foreign banking, amplify
            or dampen these shocks. The authors find that many of the
            regulatory characteristics that have been found to deepen a
            financial system and make it more robust to crises-notably
            those which empower the private sector-also appear to reduce
            the sector's ability to provide short-term insulation
            to the macro-economy. It is as if prudent bankers are
            reluctant to absorb short-term risks that, if neglected,
            might cause solvency and growth problems in the longer run.
            Forbearance might dampen short-term volatility, but at the
            expense of the longer run health of the banking sector and
            the economy. One way to avoid this apparent tradeoff is
            evident: banking systems which have a higher share of
            foreign-owned banks, a feature already associated with
            financial deepening and lowered risk of crisis, also seem to
            score well in terms of short-term macroeconomic insulation.
repnme: repnme: Banking policy and macroeconomic stability
            - an exploration
display_title: Banking policy and macroeconomic
            stability - an exploration
listing_relative_url: /research/2002/06/1942076/banking-policy-macroeconomic-stability-exploration
topicv3: Economic Growth m1326241 471,Deposit Insurance m1326722 322,Macroeconomic Stability and Growth
            m1326923 1088,Financial Sector Development m1327681 1920,Financial Institutions m1505015 3797
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: Development Research Group (DECRG)
no_of_pages: 44
model_extractions: POLICY RESEARCH WORKING PAPER _2856_

# Abstract

Whether and when does banking serve to stabilize the economy? **Caiofpi10 dIU rILVIIil** VieW **LIIe Ubing** system as a filter through which foreign and domestic shocks feed through to the domestic economy. T he filter can dampen or amplify the shocks through various credit market channels, including credit growth, import of foreign capltal, and possibly interest rates. The question is whether the prudential quality of banklng, as proxied by measures of regulatory quality and openness to foreign banking, amplify or dampen these shocks.

The authors find that many of the regulatory characteristics that have been found to deepen a financial system and make it more robust to crises-notably those which empower the private sector-also appear to _reduce_ **theI** secoLL' aSilLy **oL** pLrv-d WhVLL-t-i - macroeconomy. It is as if prudent bankers are reluctant to absorb short-term risks that, if negiected, might cause solvency and growth problems in the longer run. Forbearance might dampen short-term volatility, but at the expense of the longer run health of the banking sector and the economy. One way to avoid this apparent tradeoff is evident: banking systems which have a higher share of foreign-owned banks, a feature already associated **Txiith** financial deepemnina ntoAIwered risk of crisis, also seem to score well in terms of short-term macroeconomic Iinsuiatilon.

This paper-a joint product of Finance, Development Research Group, and the Financial Sector Strategy and Policy Department-is part of a larger effort in the Bank to analyze bank regulation and supervision. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Agnes Yaptenco, room MC3-446, telephone 202-473-1823, fax 202-522-1155, email address ayaptenco@worldbank.org. Policy Research Working, Paners _are_ also nosted on the Weh at http://econ.worldbank.org. The authors may be contacted at gcaprio@worldbank.org or phonohan@worldbank.org. June 2002. (37 pages) _The Policy Research Working Paper Series disseminates the findings of work_ **_tn_** _progress to encourage the exchange of ideas about development Issues. An objective of the series is to get the findings out quickly, even_ **_if_** _tne presentations are less than fully polished. TIne papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this pap_ **_aretIrC-y_** _those of athor._ **_Uthe_** _Thy_ **_dot_** _not;recessar;y represent the view of the Wor!d Bank t_ Er-"xe-"".- _e countries they represent._ Produced by the Research Advisory Staff
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# I. **Introduction**

In view of the depressing record of the last two decades with banking crises around the world and, in particular, in emerging markets, and it is understandable that authorities are interested iih ""hethr er^t (and w hen) r bankn serves+ oth;o th onrAv orJntv e crisis of bank insolvency has the potential io push the economy into a siump, in what is the most extreme form of credit-driven macroeconomic cycle. This is an example of bad banking worsening macroeconomic performance, and episodes -in which banks are alleged to contribute to booms or asset bubbles are not difficult to find as well. But could some forms of "good" banking also have a destabilizing role?

For example, worsening creditworthiness conditions as a slump gets under way can lead a cautiously managed bank to raise its credit quality thresholds and shift to safe **assetq** such **as** govemnment **hnnds;** the **enquinor** cretlit crnnch can exacerbate a downturn . **1002.** C **.Q..l.a** T . I n n l. **... ..** ti._ **%ji%,LLjLG.LU%L', I 7JUJ_P** **_LIejLIkCM%U-L_ V~VV1L, I 77i II W UJ1I,** **_177.))._ ilarL UPLUIII UIV,** opposite can be the case, with increasing confidence triggering a relaxation of credit standards and a surge of credit driving the economy even higher - and amplifying credit cycles. Some authors have noted that the tightness of supervisory guidelines can act in the same pro-cyclical way (cf. Berger et al. 2001).

Unfortunately, in assessing the importance of each of these models in practice, the econometrician is faced with difficult problems. While banking crises can contribute to a subsequent output dip, it is equally true that adverse output shocks can trigger a banking rr;eis(MTFAI **1** Q9 Hognarcth et al. **2)OAfl flistanctinengcr ca21ep** ani **Pffpnt** ie **wvu** **_Aifficil_ in** puctice. LiKeWiSC, **iL** is -us-aniy **naru** to **ucLemUne** whether a particuiar decline i credi can be attributed to demand or supply shocks. The relevant structural equations are
usually not well determined, as evidenced from the large literature on the East Asia crisis and the potential role of a credit crunch there (Agenor et al., 2000; Ding et al., 1998). An alternative approach to addressing the question of good banking and macro OLCL;LJL At **_LW_ LU** A **MALLF** OWL&&_ 1LOLL **LJ.LA%.JAIO** **_V._** r **_tJ AL1_** ; **_%JM LAL_** t **_LA_** _V_ A _-_ C **_fl_** performance of economies by reference to tnese instruments. **Tne** advantage of tuis approach is that it can provide guidance as to the type of banking system that government officials could expect to maximize stabilizing influences. Two distinct types of instrument on which some data are available are (i) the nature of bank regulation and (ii) presence of, or openness to, foreign bank ownership.' Already there is a literature on the cross-country contribution of financial depth to macroeconomic stability (Easterly, Islam, Stiglitz, 2000; Beck, Lundberg, Majnoni, 001) **T.It c-ncliicet** that deeper **financialv** sytems - at leat **unp to a** certain noint - do seem **Lo UV** able to insulatLe **ecUUVIUIe** against e **L** La O o VL shIock. **TJh L-tLLion** posed in this paper can be seen as addressimg **tte** same question out along adiferent almensions. of banking sector quality. While the presence of reputable foreign banks is usually held to contribute to the institutional strength of the banking system (cf. Levine, 1996), heavy reliance on foreign banks could be destabilizing if they introduce or transmit foreign shocks to a greater extent than they absorb shocks of domestic origin.

Schematically we can see the banking system as a filter through which foreign an.d dorlmestic shocks feed L'1o0ug to the dom.estic econo.my. **_Tae_** filter _cAn_ **Aov,en** or amplify the shocks, through various credit market channels including credit growtn,

**The** mainr **qnurne** nfmnat nfthic data is **the Wnrld** Rank'c qurvev **nf reoultinan** (Rarth-Canrin-Levine 2001a)

3
import of foreign capital and possibly interest rates. Our question is whether the prudential quality of banking, as proxied by measures of regulatory quality and of openness to foreigm bnvking, amplify or dampen thzese shocks. Barth, Caprio, and Levine ,e.---- o __ .e.,_ _______U.___1 .- s__e s _t1 _:.1z **LVUU** ID) **lOUIU** LUUL **sUmr** apt;{; ul UIC; [;g,ULUIy **;lUVLrU1U11IIL tau uIp ILUU 5LLU4LtW** increased financial depth as well as reduce the likelihood of fmancial crises, and here we look at whether the same or other features of the regulatory environment can dampen short-term macroeconomic volatility.

Although it is hard to identify a statistically clear role for different aspects of the regulatory environment among the many factors influencing overall macroeconomic volatility, when we look at the way in which banking system balance sheets evolve in respanse to shocks; we do find systematic natterns. Ln general; many of the regulatorv chte.t **t have** been **fnd.A** **_+t_** Adepe a **Cincn-al** **_stea ..._ r.** **_l,a_ it** .. mo:e r,lobt **Ik1a1a%,%V,L 1LaL1, LUQCL JiiLaV%, U%,.IJ IL%JLU1L%S** **_&%J_ CS~.J~L A1U JI 11UAL& .OJ .L~LA I4fl** .. -.. ****V f-** - to crises -- notably tnose which empower the private sector -- also appear to reduce the sector's ability to provide short-term insulation to the macroeconomy. It is as if prudent bankers are reluctant to absorb short-term risks that might cause solvency and growth problems in the longer run. But this apparent trade-off can be avoided: banking systems which have a higher share of foreign-owned banks, already a feature associated with financial deepening and lowered risk of crisis, also seem to score well in terms of shortterm macroeconomic insulation.

**Tn** the next section, we review sone of the earlier efforts to addiress these issues= Sectio-n 3 fl-10ws -Wi'Ul new **emILpinui WUIk, aiU** sec.Lon **It** corcludes **wiUth auviCe oru** policymakers.

4
# II. **Banking on stability: what do we know?**

..no degree of regulatory wisdom could; or should- have made the 1920s a profitable time for banks in agricultural regions affected by drastic declines in prices **_arLdJ_ laUdU V** VuTes...'V **LIL 1UrGLUL1.AJL.Vn** co .hve **V** dor,e, **bULtL did LLVo d,** mk **ILNh LV UJe** system as a whole less susceptible to shocks and more resilient in its response to failures. Calomiris, 1989 There has been little disagreement that one of the important goals of banking and, more generally, finance is to help individuals and society cope with changing economic

**,rpuilmat~ant'** **_(Tp. u;n_ 19** ?Q7) On. of the mn.t hbasic **firlnotinne** of ,fin§nn, **.nnmplu** the mobilization of za-vmgs, itslfi represenits a way **for** MUUIVIUuLLS **Lo** PtULMc UiIiCisCVUS frUm economic downturns. And from the (small business) man on the street, looking for a loan, to the sophisticated consumer of derivative products, the function of transforming risk (reducing it through aggregation and enabling it to be carried by those better able to bear it) also is a key way to deal with economic volatility (World Bank, 2001).

But is banking a source of stability? Although they note that the distinction can be overdrawn, Allen and Gale (2000) suggest that markets tend to be destabilizing, whereas banks and other intermediaries, by virtue of being able to re-contract more seamlessly, help **_toe+al7_** co.me **_AA_** d _at_ lpeast theoreic*a!!y, bar bs sholo be f ard=!ot-mg in their decisions. Tney snould nold a well diversifiea portfolio, taKing provisions and holding capital in order to ensure their survival. Banking and the building of special relationships does not fit with the perfectly competitive model, and bank charters have a value, which bankers can capture by making sure that they survive. Failure in banking, as in other industries, can send valuable signals and should be permitted, but there is a reduction in information capital when banks shut down, so that society suffers some loss.
'Bad' banks are those that risk failure either deliberately or through myopic decisions on riQl-tadinar hit at lps.qt in this thenretinl appnrnoa cy,nti hbnisr1 will n1 tweigh the had. Nlevel'hUeless, it **is** nIIL WIULOUL oI11e irony U14L **ill** IU,aly **_UbIaUrin_** crises : - **4V** Uh **UI** 1920s and 1930s, among other episodes - it has been noted that the banking sector itself appears to have acted to amplify risks rather than to help mitigate them. What could cause such amplification?

Some have argued that regulators are to blame: by tightening capital regulations or raising provisioning standards after a boom is already well underway, or indeed after one has begun collapsing, banks may be induced to vary their lending in a pro-cyclical fashion (cf Berger et al., 2001). And some features of the 1988 Basle Accord, such as **+lie lo^,1,m r4. w,l** **_'ii,a_** for r. creit, **nhr.,.e** A **air.d ;"A;-;Aiio11%y** be sensible fo: **brkso biit** coueciuveIy can mnauce an screased **rdUto** O snorL-ierm Io woI a e o ana tnereiore greayer financial fragility, meaning more economic volatility.

Others claim that the rating agencies are the culprits: by downgrading companies or countries after a slowdown has already begun, an application of existing capital standards in most countries would automatically lead to a tightening of credit conditions. Although the evidence suggests that rating agencies do a respectable job of anticipating companies' misfortunes, they appear to perform less well when it comes to country risk (cf Ferri- Liu and Mainoni- 2001).

riiIU A _-A_ still other alu1iJ **'JU1141** CU5ui M -ue +U.+ **ULGL** It **IL** iS 10UIV +Ue **LU** Ue-s- **UIALIM** O 1 *uhemselve **UIl1 I** . **VV** **_"AIJA'LLU_** =in **_L5_ Ir** lmlIglk **Ii1LI,** behavior. Tnis behavior could be entirely rationaL. Errors in judgment may be punished more severely, both by the market and by internal compensation schemes: when the bank or the analyst makes a mistake in isolation, adverse consequences may be more
sianificant than one made in good company. Alternatively, the manner in which bank executives are copensated could _mnore_ actively lead to **npterntiaI** _prn_r_ **vrli'a** lepnding **if** compensation is oaseu on **uie** snort-run performance **o0b DaiK** SLOcK priceS, Uue meiCurLLial tendency of markets will be transmitted directly to banks (John, Saunders, and Senbet, 2001).

Volatility, regardless of its source, is a legitimate source of concern in a world of less than complete markets, because individuals cannot costlessly enter into contracts for all conceivable states of the world. This statement holds with particular force in emerging market countries where the variety of financial services available tends to be more limited than in more advanced countries- Moreover- real- nominal- and financial Voliclity all **cui** g.ea'.e;A1 1ir.emerging11r, **111ua.LS .Ur I** to Ldue hslle; **sie .** Lar.Id **U.IJY** greater economic concentration (Caprio-Honohan, 1999, and World Bank, 2001), so if volatility matters in high-income economies, it must have been an even greater source of concern for developing countries.

Bernianke and Gertler (1989) and Gertler and Rose (1994) note that shocks to net worth can translate into a greater real volatility in the presence of credit market imperfections. The more significant are information problems, the more bankers will rely on the collateralizable net worth of borrowers, changes in which can lead to simultaneous **pvnanrncn** or chrinInuPa nfhWnlk hbann_e shppts, lead(Iina to creatpr **vnbItlitv** nfrea! ;nronm **anaI** 11iation, **aunu uLLus ateleung cionoiinuu weLxre. K<iyoaid** anu ivioure **ki** yy 7) **aiso noLC** that such imperfections can increase the effects of temporary shocks and contribute to their persistence. The assumption that these imperfections are more pronounced in developing countries, consistent with the well-known lack of financial development
there, makes it all the more likely than emerging markets will be particularly affected by greater volatility. Banking is also important because for most countries it is the primary channel to break the link between domestic investment and savings, thereby permitting a morer eff.icint alloartiosn oef.capital wowrldoide.

So now can countries achieve a banKing sector - more 'good' banks and fewer bad ones -- that mitigates, rather than magnifies economic volatility? Here the answers are thought to be well-known: adopt international best practices for everything from accounting and corporate governance to bank regulation and supervision. In addition to suffering from some circularity (essentially telling developing countries that they would become richer if only they adopted the institutional framework that advanced countries evolved over many generations), these recommendations for best practices are based exclusivelv on 'armchair emnpircism='

**_'.Jll aL1VV%,I_ iiiiLIJIL UI., LV** **_V%AA%J1LI~.111U_ V 1UJ~Li11W1CLL%1C.L)L..4** ~ "Ai~U~~UJM ~~~~.-U .U. _ApA_ . :-t T _.A.' -- A_ ..... Majnoni (2001) find that although real sector shocks are dampened as financial systems develop, monetary shocks are amplified: firms depend more on external resources with significant financial sector development, which exposes them more to monetary or financial shocks. 2 But this still begs the question of whether countries with deep financial systems are equally capable of dampening even some forms of volatility. Are some types of deep financial system more effective in this respect than others?

To fill this void, Barth-Caprio-Levine (2001b) collect data on regulatory and sup1rvisory pra ti^es aroulnd the world and find that nuimerous regculatory featulres, such as regulatory barriers to baik entry, regulatory restrictions **on** bank activities, greater

> **2** Easterlv. Islam and Stizlitz. (2000) found that volatilitv decreased with financial sector development until very high levels of development are reached when volatility appears to grow.

8
supervisory power, and government ownership of banks are positively associated with government corruDtion except when political onenness is pronounced: for most countries.. **_rn.fnfo risory_** sup. **ann,v snr** go **x,niths nroat.e:** **_narrnrt._ an** ar.d **n,vro:se iutran,** 00 **sfar onb** development and stability. More positively, they nnd that reguiaiory and supervisory strategies that focus on empowering the private sector (improving transparency and disclosure) and limiting the adverse incentive effects from generous deposit insurance work best to promote bank performance and stability. An additional feature of the regulatory environment that helps bank stability is found in their analysis to be the ability of foreign banks to enter the local market. In Barth-Caprio-Levine (2001b), the dimension in which stability is measured refers to banking crises. But even if no crisis oCniirz hbanking can nerfnrm an inRiilating fiinctinn- **_aq_ iq** examined figrther **helonw** Most+ **.VLVUOL** o*U'e **VUL&J1** approachLes **U LFGid1** tou: **Lv Ua1 cqueuvui** usinfcso **fUI..aU UULi UiLLuvLuu** n:vv **cU4I** as, **a.LUse** cud evenq. individual features of the regulatory environment. Jordan, Peek, and Rosengren (2000) find that U.S. banks which disclose less information then encountered more severe market reaction on eventual announcement and that this reaction was potentially contagious. In other words, better disclosure was at least consistent with lower volatility in the stock market prices of these banks. An earlier effort by Peek and Rosengren (1995) found that banks holding low capital ratios were forced to cut back more on their real estate portfolio in bad times, suggesting that bad banking can indeed exacerbate real Other research has examined The impact oI foreign banks, either in their offshore activities or onshore in industrial and emerging markets. Goldberg (2001) uses bankspecific data on U.S. bank lending to foreign countries, and finds that, while in general 9
these are not sensitive to local output and interest rate conditions in emerging markets, the volume of U.S. bank claims on foreign countries is quite sensitive to changes in U.S. conditions. This finding echoes that of Peek and Rosengren (2000), who established how JTanese **hailra** milljla harkIr **fwdnm** T T **leni,Engic ir.** th.e 1 OOn9 a,. th2at thk.e r-trv wm.kmPhnt had reai economic effects im seiect U.S. reai esiate marKets. ims suggests uiat ioreign barnks may help mitigate the effect of domestic shocks but could amplify the impact of foreign shocks. Those results were strongly driven by cross-border banking activities; in contrast, local operations of foreign-owned banks may be less ambiguous in their contribution to stability. For example, Crystal, Dages, and Goldberg (2001) find that in Argentina, Chile, and Columbia, foreign-owned banks showed not only high but more stable loan growth and higher capital asset ratios. This important finding strongly suggests that foreign-owned banks provide stability and do so as a result of their greater financial OLU-."'LI1L F%11,JLJIF **UO VV%,11** V4AL4% **LLAj** ML , **U%.LL%,l** 1%,ULLJLLV,%L **~L I %JJ ".I.,** '.VW'1 **GUIWJL%%i~** less myopic.<sup>3</sup> To summarize then, the literature provides some hope that certain aspects of the banking environment can help reduce volatility in emerging markets. In the next section we look at data on bank lending behavior in a wide cross-section of countries to see what light it throws on this issue.

> 3 _C!r_ ke, Cull, and Martinez-Peria (2001) aln shnw that anreqq **tn credit hy** mall- and mediurn-smRle enterprises is greater with a higher foreign banking presence. Since many countries have resorted to expensive directing credit programs to solve this access problem, this finding would also suggests that foreign bank entry improves long-term stability as well.

10
## **III Using Aggregate Balance Sheet Data to Assess the Insulating Potential of the Banking System**

If a banking system acts to stabilize or destabilize macroeconomic aggregates, this should become evident in the way in which the size and composition of its balance sheet evolves in response to shocks. In this section we look at the short-term dynamics of banking-system balance sheets as they change from quarter-to-quarter. In contrast to previous work examining the probability of crises -- relatively rare events occurring **nprhanoe nnp nr turiwn** in a nmlqrtPr-. **nt-lirv** -- ofur ga!n is **_tn_** examine the ability nf hanking systLewLs to iis-ulalte .iU-L1qur.LLy **ULUU** baUnce.

T lhis goal requires linking two distinct sources of data, namely quarterly baiance sheet aggregates and information on structural characteristics of the banking systems. For the latter, we use the database of Barth, Caprio and Levine (2001a), which defines the outer margins of our sample of countries. For the former, we turn to _International Financial Statistics (IFS)._

# **_IIII. Simplired Banking Svstem Balance Sheets_**

**TI.xrn upnonn** what is in **p%r.inrpleP** a icnmmnn e-t **nf** defintions IS c-o.ntsine monetary survey data on well over a h-ulndred wuliulueL, **Una4UUU1 Vhl.UUtL t11** of **Ut** countries for which we have banking quality data. Our focus is on the component data for deposit-money banks, not including the monetary authorities. But the balance sheet classifications of the monetary survey are too numerous to allow for a cross-country study without considerable consolidation and rationalization. A total of 44 distinct balance sheet category codes are included in the monetary survey, though any given country only has entries against a subset of these, typically fewer than twenty. Even 20
classifications is much too detailed a breakdown for the purpose at hand, namely to understand the influences on the broad allocation of different sources of funds to different 1 **nereioret wu** nave **simpliieu** anu ConsoluateU Lthe Ua-w **i-lou** a s1implifu **IUFIIItIL,** the same for all countries, distinguishing between just six broad categories with convenient notation as follows:

|_Assets_|_L_|
|---|---|
|aloansandadvances|c<br>capital|
|_b_billsandotherliquidinvestments(net)|ddepositsanddeposit-typeinstruments<br>_e_netotherliabilities|
||f<br>netforeignliabilities|

Here a ("advances" - though we use the term interchangeably with loans) equals total domestic credit, including claims on central, state and local governments (these expressed net of deposits), public enterprises, nonmonetary financial institutions and the private sector. The remaining asset-side item b ("bills") includes bank reserves net of credit to banks from the monetary authorities. The item c "capital" is the entry under **canitl acinnte** in **_IR.^_** it doens **nnt** in **a!i** nnces mrreqnnnd **tn** recmIntnrv caniti **lintder** the B 1asel conveifions. X L'e I*uJmjor iteML **UI UVIL LiaUbL1L1 1d** Upsits," "e **whrn,.IcIudIesIIU nUoL** only demand and time deposits (other than the public sector deposits aiready netted out of a) but also money market and other liquid liabilities. The residual item _e_ also includes bonds issued by banks. Net foreign liabilitiesf is self-explanatory. Detailed definitions are included in the Annex: "Consolidating the monetary survey".

Over time, each of the elements of the balance sheet evolve, but at any given moment, the balance sheet identity is satisfied by the data for each country: _a+h=e+d+e+,f_
This identity reflects not only the nature of banking _transactions_ but also the fact that _valuation chanoes_ (such _ac_ changes in loan-loss nrovisionning) give rise to offsettinL chgesr,V~a **Ln L1 L** L+ent **LUi, capJital.** in order to look at the evolution of the typical balance sheet structure in our data set, we express each element as a percentage of the sum of the two asset items a _+ b_ (advances plus bills). In interpreting the resulting ratios, note that this denominator is not the same as the balance sheet total. For one thing, borrowing from the central bank is netted out of "bills". Also, foreign assets are netted from the liability figure "foreign liabilities". With this caveat, we see from Figure 1 that deposits dominate the liabilities and advances the assets side of the mean portfolio structure.<sup>4</sup> The other four elements are, **n** averag **rath,-r cmslI VMPvPrth1PQe wh.en wp** look **at the variatiAn both. het.wpn** coUDnILe **duU** o **UVa L LdV i** 7(199-200), WU **UdiLsVVer** ultL ech of uLU SIAe le mnts contributes approximately the same amount (Figures 2a and 2b). This confirms that none of the elements of the chosen grouping of balance sheet items can be ignored in understanding the portfolio dynamics.

Over time, there has been a trend towards declining relative importance of the two large items, advances and deposits, as shown in Figure 3a, which shows the value for the median country at each date. Each of deposits and advances has trended downwards at a rate of between 0.5 and 0.7 percent noints ner annum. The slack has been taken un by an increase in net liquidity on the asset side and 1maiLy by capital itemLs on the liability side Figure 3b). Tnese trends presumably reflect increased reguiatory emphasis on capitai and liquidity, as well as to a shift away from the use of discount lending by central banks.

**4** r ne fgure snows uIc mii o-ver 7 i co-unuies for achn couniry s mcan -... on quariwy atn uuring I------- I i9y9Qi--~ 2000Q4.
We also notice that fluctuations in the balance sheet aggregates are sizable: movements of several percentage points even for the median of over 70 countries: intdielvlida cou ntries exper-enced much more volatility.

SO WIaL Ia.t **aU1** ULLd **UL L:Us VUlaUlILl, a.1U LIhW UV** UIhe **VaIy Ga Uy** b--el different types of banking system?

Figure 1 <!-- Start of picture text --> hban balance sheet structure<br>l. 2 i<br>--<br>0.8 M advances<br>0.6 _o0 capital<br>0.4 C3 deposits<br>* other<br>-0.2 _ l l E @foreign (net)<br>Assets. Liabilties<br>-0.2<br>(share of bills+advances)<br><!-- End of picture text --> 14
Figure 2a <!-- Start of picture text --> Standard deviation of elements of balance sheet<br>(across countries)<br>advances<br>deposits<br>foreign (net) ____<br>0 0.05 0.1 0.15 0.2<br><!-- End of picture text --> Figure 2b <!-- Start of picture text --> Standard deviabon of elements of balance sheet<br>(across dates)<br>advances I<br>deposits<br>foreign (net)<br>0 0.05 0.1 0.15 0.2<br><!-- End of picture text -->
Figure 3a <!-- Start of picture text --> Trend in balance sheet composftion<br>ir.-in ItUlem<br>0.95 1 ^ - N<br>0.9 - Advances vs bils<br>- Deposits vs other<br>0.851 V~~AA A<br>0.85 1W<br>0 75 ... .....<br>90 91 92 93 94 95 96 97 98 99 00<br><!-- End of picture text --> Figure 3b <!-- Start of picture text --> Trend in balance sheet composition<br>o-Uhar lmxb RUS<br>0.2<br>0.15<br>0.1 -Capital<br>-Other<br>0.05 ~ A Forein liabs (net)<br>n1-..,.<br>-0.05 J<br>90 91 92 93 94 95 96 97 98 99 00<br><!-- End of picture text --> 16
**_III.2 Using the monetary survey data to assess the banking system's absorptive_**

**_capacity._**

> Deposit shocks can be severe, as witness the dramatic experiences in Argentina in 1994-95 and again during 2001, when deposits fell by over 20 per cent and 10 per cent respectively, or in Turkey in 1994. The heightened depositor uncertainty which they typically imply can reflect heightened lender uncertainty also, but even if the bank lenders do not have a heightened sense of lending risk, they will have to find alternative sources of funding if they are not to shrink their loan portfolio in response to a withdrawal of deposits. Fluctuations in loans in turn can drive macroeconomic

flctuationsn SO w.e want to know whether the banking syste-m **dnoe in fiAt** t to insulate *e VUIoLL-r **Uk iofar iLumL** cAexogen-ious shocks in dUepsJitL, WIUL **Ule piU.JL11pL1UionU ULd** such1 insulation is socially beneficial.

Even if deposits remain stable, disturbances in loan-loss experience can affect the banks' capitalization. This in turn will lead to other portfolio adjustments including fluctuations in lending impacting the macroeconomy. Here again we want to know if the banks are prone to cutting-back on new loans simply because of loan-losses (as distinct from cuffing-back in a prudent response to heightened risk.) If they do so, this is likely to exacerbate an economic downturn and as such be socially undesirable.

Tn the case bo%th of shocks to deposits and to capita, it is evide.nt that simltaneity and **ifeedback** wil; be a cruciai issue. r or exampie, a poor narvest **wiii** tena to affect Dom credit demand and deposits, without there being any causality from the latter to the former. In what follows we use standard econometric techniques to correct for this problem.

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