According to the empirical literature, from 1990 through 1992, Canada, the United Kingdom, the United States, and Finland had experienced supply-side crunches in parts of their credit markets. So had Japan in 1997 and 1998. During the crunch, credit worthy borrowers cannot get credit or cannot get it at reasonable terms; Would-be borrowers are unable to fund their investment projects; Lenders allegedly exhibit an attitude of excessive caution which may or may not be traceable to regulatory distortion; Banks reallocated the balance-sheet-asset by decreasing their loan holdings while dramatically increasing their security holdings (Green and Oh, 1991). This paper attempts to develop a dynamic general equilibrium model of financial intermediation and occupational choice based on empirical regularities to study the credit crunch and possible policy solutions.
What caused the credit crunches in these countries? The following hypotheses have been proposed and tested: (1) Risk-based capital hypothesis. To minimize the risk of the international banking system and also to minimize the competitive inequality arising from differences among national bank-capital regulations, the Basle accord was signed by the G-10 countries in 1988. The agreement specifies minimum capital adequacy requirement using different risk-weighting schemes. For example, banks are required to have 8% capital baking for loans and less percentage capital backing for government securities.
Potentially, this risk-weighting scheme encourages reallocation of the banks assets to meet the new risk-based capital standards. The capital requirement was phased in from the end of 1990 and took full effect in 1992. (2) Higher regulatory scrutiny hypothesis. Bank regulators increased their scrutiny of bank-lending standards and loan holdings, resulting loan contraction. (3) Voluntary risk reduction hypothesis. Bank managers voluntarily reduced the financial and portfolio risk.
For the credit crunch in Canada, the results in Wagster (1999) conform to the risk-based capital requirement and higher regulatory scrutiny hypotheses. For the United States, Wagster (1999) show that none of the above hypotheses can be eliminated as explanations for the U.S. credit crunch. Similarly, Sharpe (1995) claims that banks curtailed their lending because of losses of bank capital, stringent bank regulatory standards and heightened market scrutiny of bank capital. The reduced credit coincides with banks having difficulty meeting minimum capital regulatory requirements. For the U.K., the higher regulatory scrutiny is the explanation for the crunch (Wagster 1999).
For Finland, Vihriala (1996) finds that the tightening of capital regulations, the substantial depletion of bank capital, and changed risk attitudes and restrictions are possible explanations of conservative lending by banks, while Pazarbasioglu (1996) also suggests that banks became less willing to supply credit during periods associated with a deterioration in asset quality, and reduced profits due to declining regulatory protection from competition, and a need to increase capital adequacy levels.
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Credit Crunch in a Model of Financial Intermediation and Occupational Choice
