Lecture 10

The Credit Channel

• This lecture re-examines the transmission mechanism in the context of the credit channel. It examines the micro-foundations of credit rationing and the channels that describe the credit mechanism.

Conventional view

• Indirect route - interest rates, asset prices, Tobin’s q

• Direct route - real balance effect, wealth effect

• expectations effect - speeds up the other two

Credit channel• Not an alternative

• amplifies and enhances existing transmission mechanism

• effects of interest rate changes are amplified by endogenous changes in the external finance premium

• external finance premium - cost of funds raised externally less cost of funds raised internally.

External Finance Premium

r

Credit

D

S

rL

rD

External Finance Premium

• Can be thought of as the margin of intermediation.

• The loan rate is the cost of external funds• The deposit rate is the opportunity cost of

internal funds.• Alternatively we can think of the internal

cost of funds as measured by the safe rate of return – such as the Central Bank rate

Monetary Policy

• Changes in monetary policy change the external finance premium

• balance sheet channel

• bank lending channel

Microeconomics of the credit channel - Credit market

frictions• Imperfect information

• costly enforcement of contracts which result in:

• adverse selection

• moral hazard

• adverse incentives

Probability of default rises with r, lowering E(π)

E(π)

r

Stiglitz and Weiss

• Type 1 rationing - when a borrower cannot borrow as much as he/she wants

• Type 2 rationing - among identical borrowers some who want to borrow are able to do so while others cannot

S-W results

• The interest rate charged affects the riskiness of the loan - adverse selection

• The higher the rate the greater the incentive to take on riskier projects - adverse incentives

Assumptions

• Assume there are many investors, each having a project requiring investment k. Each investor has wealth W< k

• All projects yield the same rate of return R but differ in risk

• Successful projects yield R*, failures yield 0

• pi is probability of success R=piR*

Assumptions• Distribution of pi is given by f(pi)

• borrowing L = k - W

• Loans are a standard debt contract (1+r)L

• R*i > (1+r)L

• investor knows the probability of success but the bank does not - asymmetric information

• Risk neutrality

Expected return to investor

LrRpE iii )1(*

Expected pay-off to bank

p

iiiB dppfpLrE0

)()1(

The pay-off to the investor is that it is decreasing in the

probability of success

LrpRE ii )1(

The high risk investor will be willing to pay more for the loan Borrowing occurs

if:

WE i )1(

Implications

• The higher is r, the riskier the marginal project

• the probability of the success of a marginal project declines as the rate of interest rises

Effect of an increase in the loan rate to the bank is:

p

iiiB pLpfr

dr

dpdppfpL

dr

dE0

0)()1()(

Interest

Loans

A

B

L*

Ld

Macroeconomic implications

• External finance premium facing a borrower should depend on borrower’s net worth

• stronger net worth enables borrower to reduce dependence on the lender

• This is in contradiction to the neo-classical view that recognises no role for net worth - Modigliani Miller theorem

Monetary Policy

• Monetary policy changes the External Finance Premium• Works through two channels• (1) The balance sheet channel• (2) The bank lending channel• As in previous slide the balance sheet channel is based on the

argument that external finance premium depends on the borrowers net worth (liquid assets minus liquid liabilities).

• The bank lending channel recognises that monetary policy influences the supply of bank credit. The shutting off of bank credit increases the external finance premium for small firms.

Balance sheet channel

• a(qt) = expected end of period equity

• qt = output

• pe = expected price

• c(qt) = cost of bankruptcy

• bt = firms borrowing

• r = cost of borrowing

• pB = probability of bankruptcy

Model

• a(qt) = peqt - (1+r)bt – pBc(qt)

• bankruptcy occurs if a(qt) < 0

• let l = employment

• lt = φ(qt), φ’>0

• w = wage• beginning period debt is:

• bt = w φ(qt) - at-1

Managers maximise end of period equity – value of the

firm

0)1(

)())()(1()( 1

te

tBtttte

t

wrpq

a

qcpaqwrqpqa

An increase in perceived risk raises the marginal

bankruptcy cost ρ

q

p

MC

MC’

Aggregate Supply

2,;,, uarwfq tttt

Aggregate Demand for labour

• AD curve contracts by:

• a real reduction in equity levels (net worth)

• increased perception of risk = u

• increased dispersion of equity levels among firms.

S

DD’

W/pe

Summary – balance sheet channel

• Monetary policy affects the net worth of the firm (or borrower)

• Increase in perceived risk increases marginal bankruptcy cost and the end-of-period equity value (net worth of firm)

• Decline in net worth worsens the external finance premium.

• Firms that have a higher level of liquidity are less effected than those that have lower levels

Bank lending channel

• If bank credit supply is withdrawn, small businesses incur costs in trying to secure new lending.

• Closing bank credit increases the external finance premium

• Firms dependent on bank financing are constrained by the implicit higher cost of credit.

• Implication of the two channels is that the availability of credit has short run real output effects

Implications for transmission mechanism

• Bank credit enters the IS curve and aggregate supply curve

• A negative shock to net worth reduces AD and AS

• Bernanke and Blinder AER (1988)

Negative shock to net worth

q

p

AD

AD’

AS

AS’

Conventional monetary shock

AS

AD

AD’

p

q

Monetary shock with the credit channel

AS

AS’

AD’AD

p

q

Credit Crunch

• The US sub-prime loans crisis had the effect of raising the external finance premium for individuals and small firms.

• The story began with the rapid rise in house prices in the USA and elsewhere in the western economies

• Although US house price inflation is not as great as in other countries what was different was that in the USA low income people were lured into mortgage commitments with ‘teaser rates’ of interest.

House Price Inflation

1997 – 2006

USA 124%

UK 194%

Spain 180%

Ireland 253%

The role of Securitization

• The sub-prime mortgages had been securitized and sold as collateralized debt obligations (CDOs).

• CDOs were given good credit ratings because the were mixed in with some well rated securities.

• Process of tranching

Example of tranching

Tranche Amount Spread Rating

Senior Class A £123.75 mill LIBOR + 28 bp AAA

Class M1 £16.5 mill LIBOR + 110 bp A

Class M2 £5.25 mill LIBOR + 130 bp BBB

Class B £4.5 mill LIBOR + 425 bp Unrated

Hedge Funds

• CDOs were held by Hedge Funds, Pension Funds, and Insurance companies

• These were used as collateral against loans extended by the banks to the Hedge Funds

• As default rates on sub-prime mortgages began to mount up, the banks began to demand cash or collateral margins.

• In the capital market the price of CDOs began to fall and the bank’s off-balance sheet subsidiaries (Structured Investment Vehicles) could not sell ABSs at the price they expected.

• So they re-appeared on the bank’s balance sheet. Which increased the capital adequacy requirements for the banks.

Counter party Risk

R

Inter-bank lending

D

BASE RATE

Supply of funds

Spread

Spread LIBOR-Base

Figure 14.4.1Interest Rate Spread

0.00000

0.20000

0.40000

0.60000

0.80000

1.00000

1.20000

1.40000

01/06/2007

08/06/2007

15/06/2007

22/06/2007

29/06/2007

06/07/2007

13/07/2007

20/07/2007

27/07/2007

03/08/2007

10/08/2007

17/08/2007

24/08/2007

31/08/2007

07/09/2007

14/09/2007

21/09/2007

28/09/2007

05/10/2007

12/10/2007

Days

pe

r c

en

t

Spread

Increase in External Finance Premium

AS’

AS

ADAD’

q

P

Conclusion• Credit channel is not an alternative to the

conventional transmission mechanism• It enhances the existing transmission effect• The empirical evidence is mixed (weak?)• securitization enables company sector to

bypass banks - credit channel is weakened.• credit channel is likely to effect SMES rather

than large corporations.