Commercial banks are distinguished from other financial institutions by their accepting deposits and provision of loans. The Federal Reserve classifies bank loans into several categories: real estate loan, agricultural loan, commercial and industrial loan (C&I), loan to depository institutions, consumer loan, obligations to state and political subdivision, and foreign loan (Saunders, 2008). Loans are the basic source of revenue and a major part of asset for banks. Loan portfolio problems have historically been a major cause of bank failure (Comptroller’s Handbook, 1998). Loans are associated with default risk in addition to the inherent risk of individual loans. Thus, according to the Modern Portfolio Theory the objective of the bank manager is to choose a loan portfolio that minimizes risk given the expected return of the portfolio.
The recent financial crisis of 2008 had severe consequences for commercial banks. According to the Federal Deposit Insurance Corporation (FDIC) 25 commercial banks failed and several others declared bankruptcy during 2008. These failures are likely to cause a decline in confidence that would make commercial banks reluctant to lend money amongst themselves or to others.
Recent papers find evidence that bank loans have declined during the peak of the recent financial crisis (August-October 2008) relative to the credit booms of May-July 2007. Contessi et al (2009b) showed that bank credit had expanded strongly in the fourth quarter of 2007, particularly for C&I loans but was followed by a sharp contraction until the first quarter of 2008. Subsequently, there was a mild contraction in the third and fourth quarters of 2008. Contessi et al (2009b) argue that lending declined for the major types of loans (C&I, consumer loans and real estate loans) and for all US banks during the third and fourth quarters of 2008.
Similarly, Chari et al (2008) argued that bank lending to non-financial corporations and individuals declined sharply during the crisis while interbank lending was essentially nonexistent. However, they added that such evidence is not evident in the aggregate data. In fact, using aggregate data they showed that C&I loans increased slightly during the crisis, consumer loans did not decline and interbank loans also did not decline during the crisis. Consistent with this result Ivashina et al (2008) found a slightly rising trend of C&I loans for much of 2008.
The use of aggregated data can be misleading when making conclusions about what happened to loans during the crisis (Contessi, 2009a). A deeper look at disaggregated data shows a steep decline of loans during the crisis (Cohen-Cole et al, 2008, Chari, 2008, Ivashina et al, 2008). Ivashina et al (2008) estimated that during August-October 2008, loans from commercial banks were 36% less than the previous 3 months.
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