Credit Boom 40h3g

Q1. What is a credit boom episode? What are the causative factors of credit booms? How credit boom episodes lead to a banking Crises? (Winter) 2006 Q2. What is credit boom? How credit boom episodes result into banking crisis? Summer-2009) ANS: What is Credit Boom or Excess Credit Creation ? Credit Creation Bank believes that not all bank clients will withdraw their money at the same time, so banks can hold less than 100% reserves and lend some fraction to other clients who purchase goods or invest. Besides deposits, banks can finance their credit expansion through 1. 2. 3. 4.

Borrowing from other banks; Reducing loans to government; Reducing reserves or money held at the central bank; and Reducing net foreign assets (borrowing abroad).

Credit Boom or Excess Credit Creation A credit boom is defined in general as an episode in which credit to the private sector grows by more than during a typical business cycle expansion. It is also defined as a period when the ratio of private credit to private gross domestic product deviates from its historical trend. During a boom, credit to the private sector increases rapidly. The danger is that as lending increases, the quality of funded projects declines, and the banking sector becomes more vulnerable. Over last 30 years, the world has witnessed 3 major financial crises – the debt crisis in 1982 (mainly Latin America), the Mexican Crisis in 1994, and the Asian crisis in 1997. All these crises share one common characteristic – ‘over-lending’ and ‘over-borrowing’. Credit can grow rapidly for three reasons: financial deepening (trend), normal cyclical upturns, and excessive cyclical movements ("credit booms"). It is important to recognize that credit typically grows more quickly than GDP as an economy develops, a process known as financial deepening or trend. Credit growth can be separated into 3 components – trend, cycle, and boom or bust. deepening or trend.. Excess credit growth is known to increase financial fragility (vulnerability). At the same time, many studies find that the probability of banking crisis increases after financial liberalization. One plausible (believable, reasonable) explanation is that financial liberalization leads to a credit boom which Credit Boom Episodes

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directly increases banking fragility which makes banks more vulnerable to any shocks. However, there exists an empirical relationship between financial liberalization and credit booms.

Credit typically grows more quickly than GDP as an economy develops. Moderate credit expansion is sustainable; however excessive credit expansion raises concerns and is unsustainable. Hence, it is hard to detect if a credit growth episode is sustainable or is unsustainable. Therefore, to observe a credit boom, one must differentiate between normal growth and excessive growth. To do so, many researchers define a credit boom episode when credit growth exceeds a given threshold. The threshold is equivalent to X times the standard deviation of that country’s credit fluctuation around trend. The trend is determined by using either HodrickPrescott (HP) filter or a vector error correction model. Caprio and Klingebile (1996) state that given the trend of financial systems to deepen gradually as countries grow, real credit growth of one to two times GDP growth might be expected in a normal time. Credit-to-GDP is one of the leading indicators for banking/currency crisis. Importantly not all episodes in which private credit grows more rapidly than nominal GDP can be qualified as a credit boom. One important reason why credit can temporarily expand faster than GDP is because companies’ investment in wo rking capital – funds needed to pay in advance for inputs into production – often fluctuates ahead of the business cycle. The resulting deviation between credit and GDP is therefore not unusual (IMF, 2004). Credit growth can also exceed GDP growth for a longer period of time due to financial deepening, reflecting the growing importance of financial intermediation. Rapid lending may thus represent a permanent deepening of the financial system and an improvement of investment opportunities that are beneficial for the economy. As empirical evidence indeed suggests, a deeper financial system contributes to economic growth (Mishkin, 2001 and Demirgüç-Kunt and Levine, 2001)3. By contrast, a credit boom is an episode of excessive credit expansion that is unsustainable and eventually collapses of its own accord (IMF, 2004). Credit growth is one of many factors explaining a banking crisis. Banking distress is more often associated with credit expansion. Liberalization allows more liquidity to enter an economy which somehow finds way to speculative projects which increases the risk of default as well as the probability of a banking crisis. When credit growth increases dramatically in the short-run, banks tend to ignore the screening process and lend out to unproductive projects causing weak fundamental. A lending boom country with weak fundamentals and inadequate reserves has a larger probability of a currency crisis. Though there is no one single indicator to predict a currency crisis, domestic credit to GDP is one of many particular useful indicator in anticipating a crisis. Credit Boom Episodes

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Governments usually set the interest rate lower than the equilibrium level in the belief that a high interest rate may reduce economic growth. A low interest rate means more funds demanded compared to saving. With a low interest rate, banks are reluctant to give loans to risky projects as the return maybe lower than the risk banks have to bear. In fact, banks prefer to lend to safe borrowers or well-connected people. Furthermore, under controlled systems, governments set high reserve requirement or require banks to purchase government bonds whenever they run budget deficits meaning that banks have less funds to lend out.

What are the causative factors of credit booms? The precise origins of lending booms are diverse. They may arise following a possibly 1-Poorly regulated financial liberalization, 2-A surge in capital inflow driven by external factors (such as low interest rates in advanced economies), or 3-Periods of strong disinflation can also boost favorable real lending conditions, higher asset prices and more optimistic risk assessments. (Gourinchas,Valdés and Landerretche 2001) 3-An “unfortunate tendency” among bankers to lend aggressively at the peak of a cycle which consequently results in extensive bad loans, made through this aggressive type of lending accompanied by loosening lending standards. 4-Or a -of-trade shock (or other types of supply shock) that boosts domestic investment or consumption or both. 5-They may also come as a consequence of a macroeconomic stabilization program: it has long been noted that exchange rate-based stabilization programs are often associated with ultimately unsustainable booms in consumption, output, and credit. Lending booms have been used to explain many banking crises, including Chile's in 1982, Mexico's in 1994, and Thailand's in 1997. In each case, reliance on foreign capital led to financial disturbances that combined banking crises with a balance-of-payments collapse. The experience of lending booms had led some academics and practitioners to advocate the use of controls on short-term capital inflows or on private credit growth. Even the International Monetary Fund has been moved by recent experience to acknowledge the benefits of targeted capital controls The researchers find that lending booms are associated with: Credit Boom Episodes

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- An investment boom and to a lesser extent a consumption boom; - Declines in trend output growth over the episode of over 1 percent; - A large increase in domestic interest rates; a large increase in the current deficit and a counterpart in the form of capital inflows; - A real appreciation of the domestic currency; - Some worsening of the fiscal situation; - A decline in foreign reserves; and - A shortening of the maturity of the external debt. During a lending boom, the typical story goes; credit to the private sector rises quickly. Leverage increases, and financing is extended to projects with low—possibly even negative—net present value, either because monitoring becomes more difficult when the volume of lending increases rapidly, which increases the likelihood of fraud (including looting, self-lending, and evergreening), or because domestic borrowers' net worth increases. As lending expands, the quality of funded projects goes from bad to worse, exposure in creases, and the banking sector becomes more vulnerable. Some scholars emphasize the aggravating effect of expected public bailouts in the event of a generalized bankruptcy.

How Credit Boom Episodes lead to a Banking Crises? Indeed, most major banking crises in the past 25 years have occurred in the wake of periods of extremely fast credit growth. Yet, not all credit booms are followed by banking crises. Indeed, most studies find that, while the probability of a banking crisis increases significantly (by between 50% and 75%) during booms, historically only about 20% of boom episodes have ended in a crisis. For example, out of 135 credit booms identified in Barajas et al. (2007) only 23 preceded systemic banking crises (about 17%), with that proportion rising to 31 (about 23%) if non-systemic episodes of financial distress are included. In contrast, about half of the banking crises in their sample were preceded by lending booms. Not surprisingly, larger and longerlasting booms, and those coinciding with higher inflation and - to a lesser extent - lower growth, are more likely to end in a crisis. Booms associated with fast rising asset prices and real estate prices are also more likely to end in crises. The relationship between Credit Boom Episode and Banking Crises is linked by a decrease in lending standards, measured by a significant increase in loan-to-income ratios and a decline in denial rates. However, the authors find no significant increase in banking and balance-ofpayment vulnerability. Nor do they find any evidence those lending booms-which last an average of 6? Years on the relative measure and 5? Years in the absolute cases -- tend to come to an abrupt halt. To analyze whether boom episodes are related to financial crises - and particularly whether they signal future banking troubles - the researchers compare the probability of having a banking crisis before and after a boom Credit Boom Episodes

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with the probability of experiencing a crisis during more tranquil periods. They find that the probability of a banking crisis after a lending boom is relatively low. Although the probability of a banking crisis up to two years after a lending boom is somewhat higher than during tranquil periods, the difference is not statistically significant. The concern is that as lending increases, the quality of funded projects declines, and the banking sector becomes more vulnerable. However, Gourinchas, Valdés, and Landerretche show that the presumption that lending booms generically lead to banking crises is wrong. While a lending boom may precede most banking crises, banking crises do not follow most lending booms. Financial development typically occurs in stages, with periods of intense financial deepening and increases in the level of financial intermediation by banks. Large increases in lending may represent a permanent capital deepening rather than just a transitory boom. The “excessive” pace of credit growth thus leads to a deterioration of the quality of bank portfolios. When it becomes clear that the optimistic expectations are unjustified, the whole process is reversed. The failure of a large number of the “bad” projects funded during a credit boom could then set off downward spiral. Borrowers unable to repay their debt (credit risk) see their collateral seized and sold by banks, which could trigger asset price declines, lower net worth and further loan recalls. If loan losses exceed a bank’s reserves and equity cushion, the bank is technically insolvent. Even in the absence of a rise in loan losses, banks are exposed to higher solvency risk if asset price declines set off falls in the value of their marketable investments (market risk).

How to Reverse Adverse Impacts of Credit Boom Episodes? What can be done to curb bad credit booms? Historically, the effectiveness of macroeconomic polices in reducing credit growth has varied (see, for example, Enoch and Ötker-Robe, 2007). While monetary tightening can reduce both the demand and supply of bank loans, its effectiveness is often limited by capital openness. This is especially the case in small open economies and in countries with more advanced financial sectors, where banks have easy access to foreign credit, including from parent institutions. Monetary tightening may also lead to significant substitution between domestic and foreign-denominated credit, especially in countries with (perceived) rigid exchange rate regimes. Fiscal tightening may also help reduce the expansionary pressures associated with credit booms, though this is often not politically feasible. While prudential and supervision policies alone may prove not very effective in curbing credit growth, they may be very effective in reducing the risks associated with a boom. Such policies include prudential measures to ensure that banks and supervisors are equipped to deal with enhanced credit risk (such as higher capital and provisioning requirements, more intensive surveillance of potential problem banks, and appropriate disclosure requirements of banks’ risk management policies). Credit Boom Episodes

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Prudential measures may also target specific sources of risks (such as limits on sectoral loan concentration, tighter eligibility and collateral requirements for certain categories of loans, limits on foreign exchange exposure, and maturity mismatch regulations). Other measures may aim at reducing existing distortions and limiting the incentives for excessive borrowing and lending (such as the elimination of implicit guarantees or fiscal incentives for particular types of loans, and public risk awareness campaigns). In response to aggressive lending practices by mortgage lenders, several states in the US have enacted anti-predatory lending laws. By the end of 2004, at least 23 states had enacted predatory lending laws that regulated the provision of high-risk mortgages. However, research shows that these laws have not been effective in limiting the growth of such mortgages, at least in the US (see, for example, Ho and Pennington-Cross, 2007). At the end of 2006, US federal banking agencies issued two guidelines out of concern that financial institutions had become overexposed to the real estate sector while lending standards and risk management practices had been deteriorating, but these guidelines were too little, too late.

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