Normas reguladoras

To comprehend the lending behaviour impact on the economic condition, it is vital to understand how the credit market works. Most of the literature on banks’ lending pro-

cyclicality behaviour based their work on Bernanke and Blinder (1988) works who introduced the credit market equilibrium through the IS-LM model. Bernanke and Blinder (1988) initially analyse the association between the credit market and monetary policy.

Literatures explaining the works of credit markets usually look at the credit view. The credit view puts a special emphasis on the role of financial intermediaries and the banking sector in particular in the economic activity aggregately. Many empirical works applied this model in estimating the credit market equilibriums and test the credit channel hypothesis and its relevancy to the credit crunch episode (such as by Bernanke and Lown, 1991; Kasyap and Stein, 1994; Peek and Rosengreen, 1995; Hancock and Wilcox, 1998).

Bernanke (1983) attempted the pioneering effort in empirical study on the credit channel. Bernanke explains the credit view relevancy by fitting output equations with United States monetary variables and by adding proxies for the financial crisis in his work. Consequently the model suggested by Bernanke and Blinder (1988) extended the traditional IS-LM model to incorporate the effect of bank loan or credit on the economic activity fluctuation or the business cycle happening.

From the credit crunch literature, the empirical evidence suggested that one of the main factors of the reduction on loan demand had a significant consequence of the real economy production activities (Bernanke and Lown, 1991; Berger and Udell, 1994; and Furfine, 2001). Bernanke and Blinder (1988) contends that the existence of direct credit channel of monetary policy to bank lending makes it possible to carry out monetary policy without large changes in the interest rate. It assumes that firms could finance

their investment of bank loans and bonds as well. The banks’ asset portfolio now consists of loans besides reserve and bonds in simple terms.

Following this view, the direct effects of monetary policy on the interest rates amplified by the endogenous changes in the external finance premium that is the difference in cost of funds raised externally through the issuing of equity or debt and funds that is generated internally by retaining the earnings. The size of the external finance premium reflects imperfections in the credit market that drives a wedge, between the expected return received by lenders and the costs faced by potential borrowers.

A change in the monetary policy that changes the open-market interest rates will be likely rises or lowers the external finance premium in the same direction. Because of the additional effect of policy on the external finance premium, the monetary policy effects on the broadly defined cost of borrowing and consequently on the real spending and real activity is magnified (Bernanke and Gertler, 1995).

This view explains what has been termed as the ‘liquidity puzzle’ – a situation where monetary drainage fails to raise interest rates. In this context, a prediction based solely on the traditional money view channel will underestimate the policy impact on the real variables. The direction of the bank’s lending does not influence the level of liquidity and inflation in the system alone but also productivity, resource allocation and the social economic order envisioned by the government.

Central bank can manage bank’s loan supply either by raising the reserve requirements or through conducting an open market operation. The ultimate effect will not only reduce the total volume of the commercial bank loanable funds but also the proportion of the commercial banks earning assets to their total assets. An open market sale of the

treasury bills for instance, will reduce the commercial banks reserve as purchaser’s issues checks against their accounts in commercial banks. Hence, open market sales will drain liquidity from the economy.

A distinctive feature of bank’s lending channel is the ability of a tight monetary policy to reduce the supply of loans beyond what ordinarily predicted by a rising interest rate. A rising interest rate resulting from a tight monetary policy will reduce private investment. As a result, a reduction in bank loans supply mostly to the small and medium scale entrepreneurs who rationed out of the credit market because of higher cost of capital.

There are two descriptions of the credit channel in the literature, the bank lending channel and the balance sheet channel. The bank lending channel central attention is on the possible effect of monetary policy on the supply of loans by financial intermediaries. The balance sheet channel, on the other hand, looks on the possible response from the monetary policy on borrowers’ income statements, balance sheets, liquid assets, cash flows, and net worth. Those variables are the indicators of borrower’s creditworthiness. Weaken in any of those variables disrupt firms’ likelihood to obtain loans.

The foundation of the bank lending channel is based on the nature of banks in mobilising deposits and utilising it in term loans and its ability to solve asymmetric information problem. For bank lending channel to exist, a reduction in reserve requirements by the monetary authority must increase the bank’s lending volume. Banks must not cut off their loan supply of a shock to reserve for simply rearranging their portfolio of other assets and liabilities. Bank’s lending channel requires that some firm without costless replaces losses of bank credit with other types of finance, but rather must curtail their investment spending (Mishkin, 2010).

The balance sheet channel explores the supply of funds of the overall fund markets. The channel arises from the presence of asymmetric information problems in credit markets. A tight monetary policy directly increases lower net worth of business firms and the more severe the adverse selection and moral hazard problems are in lending to these firms. Lower net worth means that lenders in effect have less collateral for their loans and therefore losses from adverse selection are higher. A decline in the net worth raises the adverse selection problem, thus, leads to the decreased of lending to finance investment spending.

The lower net worth of business firms increases the moral hazard problem it means that owners have a lower equity stake in their firms, giving them more incentive to engage in risky investment projects. Taking on riskier investment projects makes it more likely that lenders will not be paid back. A decrease in firms net worth leads to a decrease in lending and hence in investment spending (Mishkin, 1997).

The analyses on the credit channel discussed by previous researchers provide only partial explanations of the stylised facts about the pro-cyclicality of the interest-based bank behaviour. Earlier research neglected banks’ behaviour during the expansion and contraction of the business cycle. Later study such as by Albertazzi and Gambacorta (2009), Gruss and Sgherri (2009), Bouvatier and Lepetit (2008), Rochet (2008), Quagliariello (2007), Bikker and Metzemakers (2005) and Bikker and Hu (2002) have provided a more comprehensive study on the pro-cyclical behaviour of the interest- based bank lending.