Economics: Banking, Growth, and Crises

GDP Time Series - USA

• The GDP time series plot reveals a lot of information about the economy.
• The plot allows us to distinguish between trends and cycles in the economy.

Growth and Banking

• Understanding the determinants of growth differences across countries is important for:
  • People living in those countries (GDP per capita is highly correlated with living standards)
  • People living in other countries (considering investing or doing business in a country)
  • Policy makers (involved with economic policy of a country)
• Growth differences are significant, raising questions about the role of luck, policies, or both.

Cycles

• The economic cycle around the 2008/2009 financial crisis is a notable example.
• It can be difficult to distinguish between trends and cycles, as seen in the case of Italy from 2007-2008.

Business Cycle and Banking

• Economists worry about short-run (business cycle) fluctuations.
• Key questions include:
  • What is a recession?
  • Why are some recessions large and persistent?
  • What are their determinants?
• The recessionary effects of banking crises will be studied, with a focus on the euro area in recent years.

Lecture Outline

• The impact of financial development on long-run economic growth
• Main conclusions from cross-country and within-country analyses
• The non-linear effect of financial development
• Empirical differences in financial development: an international perspective
• The euro-area crisis

Banking and Growth: An Old Debate

• There is an ongoing debate in economics about the role of financial development in economic growth.
• Robert Lucas (1995 Nobel Prize) argued that finance is an overstressed determinant of economic growth.
• Merton Miller (1990 Nobel Prize) argued that the idea that financial markets contribute to economic growth is a proposition too obvious for serious discussion.

How do Banks Promote Growth?

• A simple theoretical framework (Pagano M., 1993) assumes that:
  • The economy produces a single good that can be consumed or invested to accumulate capital.
  • Aggregate output depends linearly on the aggregate capital stock.
  • Capital stock is a function of savings and investment.
• Financial development can affect economic growth through three channels:
  1. By funneling savings from savers to firms (intermediation efficiency).
  2. By improving the allocation of capital (allocative efficiency).
  3. By affecting the saving rate (saving rate).

Theoretical Prediction

• The growth rate is a function of financial development, which affects the economy through the three channels mentioned above.

Financial Development and Growth: Growth Regression

• The following statistical relation is established: gi = α + βFDi + εi Where gi is the average growth rate and FDi is a measure of financial development.
• Key issues in this regression include:
  1. Measuring economic growth and financial development.
  2. Determining the sign and significance of β.
  3. Interpreting the relation as causal.
  4. Determining the channel of influence.

Financial Development and Growth: Goldsmith (1969)

• Goldsmith (1969) estimated the growth equation and found a positive and significant relation between financial development and economic growth.
• Criticisms of this study include:
  1. Limited sample size (35 countries).
  2. Lack of control for other factors influencing economic growth.
  3. Failure to examine the relation between financial development and productivity growth.
  4. Inadequate measurement of financial development.
  5. Unclear direction of causality.

The Growth Regression by King and Levine (1993)

• King and Levine (1993) used a sample of 77 countries over the period 1960-1989 and estimated the following equation: gi = α + βFDi + γXi + εi Where Xi includes explanatory variables such as income per capita, education, and political stability.
• Measurement issues in this study include:
  1. Alternative ways of measuring economic growth and financial development.

KL (JME, 1993) Results

• The results show that finance predicts growth, but the study does not deal formally with the issue of causality.

KL (JME, 1993) Interpretation

• The interpretation of each β coefficient is like in a lin-lin multiple regression model.
• The sizes of the coefficients are economically large and statistically significant.

Causality in Economics

• The estimation may represent a spurious correlation with no causality interpretation.
• Causality is important for policy makers to guide policy choices.

What's After King and Levine (1993)

• The empirical literature has moved in two directions:
  1. Identifying the causal impact of financial development in cross-country studies.
  2. Identifying the channel(s) of influence of financial development with industry-level or within-country studies.

Further Developments in the Literature

• The literature has addressed the issue of causality using quasi-natural experiments and instrumental variables.
• Examples include:
  1. Levine, Loayza, and Beck (2000).
  2. Rajan and Zingales (1998).

Summary of Results in Levine, Loayza, and Beck (2000)

• The study confirms that countries with better functioning banks grow faster.
• The adoption of a legal origin (e.g., English, French, German, or Scandinavian law) affects financial development.

Summary of Results in Rajan and Zingales (1998)

• The study shows that industries that are more dependent on external finance benefit disproportionately more from financial development.
• Financial development disproportionately boosts the growth of value added of industries that are naturally heavier users of external finance.

A Within-Country Study with Quasi-Natural Experiment

• Pascali (2016) finds that differences in local banking development related to an historical event during the Italian Renaissance are related to higher financial development nowadays.

The History of Italian Banks

• The history of Italian banks is influenced by the presence of Jewish communities and the creation of Monti di Pietá.

Results in Pascali (2016)

• The study establishes a causal effect of local banking development on GDP-per capita of Italian regions.
• The effect goes through an increase in firms' productivity.

Issue 3

• The impact of financial development on long-run economic growth.
• Main conclusions from cross-country and within-country analyses.
• The non-linear effect of financial development.
• Empirical differences in financial development: an international perspective.
• The credit channel of monetary policy.
• The Great Financial Crisis.
• The euro-area crisis.

Non-Linear Effect of Financial Development

• Is "too much" finance a potential issue?
• Arcand, Berkes, and Panizza (2015) study the non-linear effect of financial development on growth.
• The relationship between finance and growth is negative when financial depth reaches a value between 0.8 and 1.

Too Much or Too Little Bank-Finance?

• The marginal effect of credit to the private sector on growth is negative when financial depth reaches a value between 0.8 and 1.

The Dark Side of Banks

• An excessively bank-based financial structure is prone to three problems:
  1. The hold-up problem.
  2. The problem of...### Politically Powerful Banks
• Large fixed costs in banking lead to concentration and lobbying for private interests or lax regulation
• Volatile credit supply can amplify economic shocks and have destabilizing effects on the economy

The Issue of Over-Banking

• Some countries have large banking systems relative to their economy, measured by income or household wealth
• Europe has the world's largest banking system, with total assets of €42tn (~334% of EU GDP) in 2013
• Rapid expansion of banking systems over the past decades has led to concerns about excessive risk-taking and sovereign debt crises

Bank Bias in Europe

• Langfield and Pagano (2016) document the rise of the banking sector in Europe relative to equity and private bond markets
• This expansion is associated with more systemic risk and lower economic growth, particularly during housing market crises
• Banks amplify negative shocks via credit supply due to the financial accelerator mechanism

Historical Behavior of Europe, USA, and Japan

• From 1880 to the 1960s, bank assets to GDP fluctuated around 70% in both the US and major Western European countries
• In the late 1980s, bank assets amounted to about 180% of GDP in Japan and major Western European countries
• Only since 1990 has Europe's banking system grown much larger than its international peers

Financial Structure and Growth

• Bank-based financial structures may feature higher risk and lower economic growth than market-based structures
• The aggregate economy is more volatile in bank-based structures, especially during times of large drops in asset prices
• Estimate of the model: git = α + β1 Sit−1 + β2 Sit−1 xPit−1 + γXit−1 + Fi + Tt + εit

Financial Accelerator

• The financial accelerator framework, developed by Ben Bernanke, suggests that economic disruptions may be generated or amplified by deteriorating credit-market conditions
• Two necessary conditions: financial markets are imperfect, and financial intermediaries operate at some cost
• When the cost of intermediation rises, banks may react by charging higher interest rates or cutting credit to clients

When Banks Matter

• Suppose there is asymmetric information between lenders and borrowers, and firms can obtain only collateralized loans
• The value of a loan cannot exceed the value of assets, and the firm's maximization problem is subject to an additional collateral constraint

The IS-LM Framework

• The IS-LM framework is augmented with features such as firms financing activities with direct and indirect markets, and the banking sector offering deposit and credit contracts
• Aggregate demand is the sum of consumption and investment, and the financial market has three markets: money, bonds, and loans

The CC-LM Framework

• The CC-LM framework incorporates the financial accelerator mechanism, and monetary policy shocks have a direct impact on the credit channel
• The credit channel has an amplification effect for a given monetary policy shock, and the accelerator mechanism depends on the structure of the economy

The Financial Accelerator Effect of Monetary Policy

• When a negative monetary shock occurs, credit supply to borrowers reduces, and the net worth of banks may be negatively affected
• The financial accelerator effect is triggered by monetary policy shocks in the presence of binding financial frictions

Macroeconomic Consequences of (Micro) Financial Imperfections

• The Great Financial Crisis suggests that financial markets are not a veil, and financial intermediaries may have a role in macroeconomic fluctuations
• The credit view developed starting from the contributions of Mishkin (1978) and Bernanke (1983)

The Great Financial Crisis (GFC)

• Macroeconomic considerations: premises to the US financial crisis, main facts characterizing the financial collapse, and microeconomic issues regarding the banking system
• Premises to the crisis: inflows of foreign capital, low policy rates, and the role of financial innovation
• The credit view at work in the run-up of the crisis: two feedback mechanisms amplified the perverse effect of low interest rates### The Housing Bubble and the Financial Crisis
• The combination of cheap credit, low credit standards, and increasing aggregate leverage led to the housing bubble.
• Securitization theoretically diversified risk, but the credit risk was ultimately held by sponsor banks or other intermediaries, exposing the financial markets to increasing credit risk and liquidity risk.
• The increase in credit risk and liquidity risk represented the seeds of the financial collapse.

The Beginning of the End

• Between June 2004 and June 2006, the US policy rate increased from 1% to 5.25%, jeopardizing the sustainability of mortgage debts.
• Around mid-2007, insolvencies on subprime lending increased, possibly due to a decrease in the expectations of house price growth.
• In spring 2007, the insolvency rate on subprime mortgages exceeded 16%, speeding up the property price drop.
• A deterioration of the prices of mortgage-related products (CDOs) started, leading to concerns about the value of structured products and the erosion of confidence in rating.
• The loss in value of CDOs and the increasing uncertainty made money market participants reluctant to roll over the short-term debt of intermediaries operating in the shadow banking system, leading to an interbank market freeze.

Chronology of the GFC

• August 2007 - mid-March 2008: distress episodes related to the collapse of the short-term liquidity market, rescue plans for Northern Rock (UK) and Bear Stearns (USA).
• Mid-March 2008 - mid-September 2008: liquidity problems turned into solvency problems, nationalization of Fannie Mae and Freddie Mac, and the failure of Lehman Brothers.
• Mid-September 2008 - end-October 2008: the collapse of the international financial markets and the reaction of central banks by cutting rates.
• End-October 2008 - mid-March 2009: the world recession and government reactions (fiscal policy).
• Mid-March 2009 - onwards: the first signs of recovery thanks to unconventional monetary policy actions.

Credit View at Work in the Recession

• The balance sheet channel at work:
  • The drop in asset prices (e.g., housing) made leveraged investors credit-constrained.
  • To return on their debt, investors had to fire-sale their assets, which depressed the price further, inducing more selling and a drop in collateral value - a negative spiral.
• Financial stability risks are usually linked to real estate lending booms, which are typically followed by deeper recessions and slower recoveries.

Conclusions on the US Financial Crisis

• The recent recession has been made "great" by the contemporaneous banking crisis.
• The amplification mechanisms from financial markets to the real economy contributed to the deepness and length of the recession.

The Great Financial Crisis in the World

• The 2007-2008 US financial crisis was not an isolated episode.
• Many countries in the world had a financial crisis in the same years.
• Caprio et al. (2014) analyze the impact of different financial determinants on the probability of having a banking crisis in the period 2007-2008.

Definition of Variables

• Crisis: a dummy equal to one if the country is classified as either borderline crisis or systemic crisis and zero otherwise.
• Net Interest Margin: the country's bank's net interest revenue, as a share of its interest-bearing assets, to proxy the banking system orientation towards traditional activity.
• Credit Deposit: the country's loan/deposit ratio.
• Concentration: the share of the country's three largest banks in all country's banks assets.
• Restriction: the value of the Overall Restrictions index, measuring the extent of regulatory restrictions on bank activities in securities markets, insurance, real-estate, and owning shares in non-financial firms.
• Private Monitoring: a value of the index measuring the degree to which regulations empower, facilitate, and encourage the private sector to monitor banks.

Results

• The results show that there are many similarities between the 2007-2008 US experience and the rest of the world.
• Interpretation of the results:
  • Net Interest Margin is negative and statistically significant, indicating that countries with a higher level of net interest margin had a lower probability to be in crisis in 2008.
  • Credit Deposit is positive and statistically significant, meaning that countries with a higher credit/deposit ratio had a higher probability to be in crisis in 2008.
  • Concentration is negative and statistically significant, indicating that countries with a higher level of concentration in the banking sector had a lower probability to be in crisis in 2008.
  • Restriction is negative and statistically significant, suggesting that more restrictions on bank activities lowered the probability for the country to be in crisis in 2008.
  • Private monitoring is negative and statistically significant, meaning that countries with a higher level of private monitoring had a lower probability to be in crisis in 2008.

The Euro-Area Crisis

• The flight-to-safety in sovereign debt markets.
• The economic consequences of sovereign debt crisis and the diabolic loop between banks and public debt.

The Flight to Safety

• When interest rates spike in some regions or asset classes, they decline in some other regions or asset classes.
• These relative price movements reflect a flight-to-safety of international capitals.
• In Europe, during the sovereign debt crisis, capital flew from southern European countries to Germany.

The Diabolic Loop between Banks and Public Debt

• Banks hold a lot of national debt for different reasons.
• The effect of this concentration of national bonds held by banks and government guarantees to banks is the foundation of the diabolic loop.
• An increase in the interest rate of new bonds implies that older bonds are worth less, generating losses for banks and increasing liability and equity risk of banks with a final effect on banks' supply of credit and ultimately investments (financial accelerator) and tax revenues.