Ebook A Disequilibrium Model of the Korean Credit Crunch
The East Asian financial crisis of 1997 caused a reduction in the credit supply in many of the region’s economies. The monetary authorities implemented a variety of monetary policies to smooth the flow of credit when the credit supply was greatly reduced during the crisis. They expanded the supply of money at the outset of the crisis and they decreased interest rates later. In spite of such efforts, private credit in real terms did not bounce back right away. It took a while for real credit supply to recover to pre-crisis level in the crisis-hit countries.
Korea also experienced such a similar credit shortage problem right at the beginning of the crisis. While much work has been done about the causes and predictability of the financial crisis itself, there has not been much research about credit crunches. In this study we identify the periods of credit crunches using an econometric model.
According to the Council of Economic Advisors (1991), a credit crunch is defined as a situation in which an unusually sharp decline in the supply of credit generates an unsatisfied excess demand for credit at the prevailing interest rates. Similarly Bernanke and Lown (1991) define a bank credit crunch as a significant leftward shift in the supply curve for bank loans, holding constant both the safe real interest rate and the quality of potential borrowers. In our study we define a situation as a credit crunch if the supply of real credit declines and there exists excess demand for real credit in the loan market. Whereas the concept of credit crunch is straightforward, it is not always easy to identify the existence of a credit crunch simply from studying the market.
To evaluate the monetary policy stance, it is enough to examine the evolution of key macroeconomic variables in normal time. But it becomes complicated during the crisis, because the relationship between monetary policy instruments and nominal income changes drastically. We will review this relationship later. Ding et al. (1999) propose an interesting hypothesis to identify a credit crunch based on the literature in this field. In a situation of credit crunch, the external finance premium is likely to increase, thus increasing the cost of borrowing. This increase in the cost of borrowing is the effect of two channels, the balance sheet channel and the bank lending channel.
The balance sheet channel emphasizes the potentially depressing impact of credit tightness on borrowers’ assets and profits, including variables such as borrowers’ net worth, cash flow and liquid assets. In a credit crunch situation, the risk premium is increased. Increasing the risk premium reduces both business profits and the value of assets that firms have posted as collateral. This will increase the wedge between the interest rates at which corporations can borrow and the yields on risk-free assets.
The bank lending channel focuses more on the retrenchment in the supply of loans. The monetary squeeze raises the interest rates even for government bonds, which may be considered to be risk-free. Banks cannot increase deposit rates by as much since they have to build required reserves. This means that banks suffer a deposit drain as investors reshuffle their portfolios towards higher interest bearing assets.
As a result of the deposit drain, banks have to adjust their portfolios. If banks differentiate between making loans and holding government bonds, they will be unwilling to deplete their holdings of government bonds below a certain level. Therefore the deposit drain will probably lead banks to restrict their loan supply. Since the majority of firms do not issue corporate bonds on the market in reality, bank lending rates will increase. Through the bank lending channel, we expect that the wedge between bank lending rates and yields on corporate bonds will increase.
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