The dramatic increase in depository institution (DIs) failures in the middle and late 1980s stemming from banking deregulations in 1980s raised concerns about banks insolvency risk and in the policy means to control this risk. The risk-based capital (RBC) requirements as a support to the Basel I replaced capital guidelines for US banks to hold a greater proportion of bank equity against assets deemed high risk. The risk facing DIs was important for policymakers because of the perceived link between their stability and the performance of the economy. The implementation of the RBC requirements saw a big shift in banking lending practices, DIs moved away from high-risk commercial loans to treasuries making it difficult for commercial borrowers to obtain credit while other sources of credit became costly causing economic slowdown. Thus, RBC may have contributed to a “credit crunch” which is defined as big reduction in the extension of credit available to commercial borrowers (Berger and Udell, 1991).
This paper seeks to determine, using state-level data, whether the precipitous drop in equilibrium loan amount in early 1990s, resulted from demand driven factors, or supply driven factors or both, for 1979 to 1996 period and how the regulatory changes impact the equilibrium loan amount. Existing empirical works by Bernanke and Lown (1991), Berger and Udell (1994), Brinkmann and Horvitz (1995), and Peek and Rosengren (1995) and others address the credit crunch issue in other ways.
A classic work on credit crunch by Ben Bernanke and Cara Lown (1991) showed the decline in the supply of credit for the early 1990s recession. The primary cause of the economic slowdown was due to lack of capital facing banks and other depository institutions coupled with waning in quality of borrowers’ caused banks to reduce loan supply hence prevent loan loss provisions. According to them, the lending slowdown of mid 1990 (July) resulted from weak loan demand, weak loan supply or both. During recession, the weak state of borrowers’ balance sheets tempted borrowers to increase their leveraged operations because asset prices are deteriorating rapidly and adversely affecting potential borrower’s net worth. As net worth of potential borrowers became questionable, the effective demand for external finance plunged thereby lingering the recovery process. Bernanke and Lown also pointed out other supply side factors: securitization of bank assets, availability of loanable funds, overzealous bank supervisors, and the possible shortage of bank equity.
Although other factors contributed to the crunch problem, Bernanke and Lown pointed out that shortage of bank equity was perhaps the strongest. Using state level data on bank loans, bank equity, and bank assets, from the Federal Reserve and breaking it down by Census regions, the New England, the Mid-Atlantic (NY, NJ, PA) and, West South Central (AR, LA, OK, TX) their work supported the “capital crunch” claim. The capital-asset ratio decline for New England was severe followed by the Mid-Atlantic States. Kliesen and Tatom (1992) echoed similar concern, where bank loans are historically issued to finance business inventories and fall in business inventories resulted from fall in bank lending.
Using New England data, Peek and Rosengren (1995) saw credit availability not related to episodes of disinter mediation (Wojnilower 1980), but rather caused by banks facing binding capital constraints and aptly named the experience “capital crunch” instead. Peek and Rosengren found that it was difficult to separate the decrease in the demand for loans that occurred in a recession from the diminished supply of loans. To avoid this they used cross section data on New England banks facing similar regional economic downturn. Mainly capital strapped banking institutions routinely modified their balance sheets by either issuing new securities (to raise capital) or routinely switching to assets that needed fewer equity, from the ones that needed more, and hence reduced loan availability to businesses exacerbating the crunch (Peek and Rosengren, 1995; Yago, 1991; Brinkmann and Horvitz, 1995).
The new RBC requirements caused banks to constrain loan supply (Moore, 1992; Baer & McElvarey, 1993). While Furlong (1990) showed how equity/asset ratio between large banks and small banks are associated with their lending practices. In a related work, Avery and Berger (1991) points out that new RBC standard are more stringent for large banks because they invest a higher proportion of their portfolios in off-balance sheet activities with higher risks relative to smaller banks thus introducing bank-size bias into the result. Similarly, using quarterly available micro-level bank data on commercial and industrial loans, real estate loans, and installment loans on U.S. banks from 1979 to 1992, Berger and Udell (1994) examine credit reallocation. According to them, newly created securitized commercial loans are ultimately responsible for a "credit crunch".
Modifying the loan-supply model of Peek and Rosengren (1995) and developing a loan demand model (Ghosh, 2008), we advance a system of equations about the loan market under imperfect competition. The goal here is to identify a credit crisis and resulting interest rate that clears the market, which enables us to determine the cause of 1990s credit crisis.
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