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The volume of credit extended by a bank can be an informative signal of its abilities in loan selection and management. It is shown that, under asymmetric information, banks may therefore rationally lend more than they would otherwise in order to demonstrate their quality, thus negatively affecting financial system soundness. Small shifts in technology and uncertainty associated with new technology may lead to large jumps in equilibrium outcomes. Prudential measures and supervision are therefore warranted.
We assess the extent to which loan losses affect banks’ provision of credit to companies and households and examine how feedback from losses to a reduction in credit is affected by the monetary policy stance. Using a unique cross-country dataset of more than 600 banks from 32 countries, we find that losses lead to a reduction in credit and that this effect is more pronounced when either initial bank capitalization is thin or when monetary policy is tight. Moreover, in the face of credit losses, ample capital is more important in cushioning the effect of loan losses when monetary policy is tight. In other words, capital buffers and accommodating monetary policy act as substitutes in offsetting the adverse effect of losses on loan growth. While most of these effects are stronger in crisis times, we find them to operate both in and outside full-blown banking crises. These findings have important implications for the interplay between financial stability and monetary policy, which this paper also draws out.
KEY ISSUES Context. Brazil is recovering gradually from the growth slowdown that started in mid- 2011, but the recovery remains uneven and inflation elevated. Output is estimated at potential with supply-side constraints, linked to tight labor market conditions and protracted weak investment since 2011, limiting near term growth. A monetary tightening cycle has started, following a period of easing. In staff’s view, excessive fine tuning of fiscal policy (including through public banks) has weakened the credibility of Brazil’s long-standing fiscal framework, while broader policy uncertainty has weighed on investment. Staff’s estimates of potential growth have been revised down and the challenges posed by eroding competitiveness and economic imbalances remain— notably low saving and investment. The Article IV consultation mission took place during May 13–24. Outlook and Risks. The recovery is expected to continue during 2013–14, supported by a pick-up in investment and resilient consumption. The near-term outlook envisages continued monetary tightening, broadly unchanged fiscal policy, and sustained implementation of infrastructure investment. Domestic risks are to the downside, linked to more sluggish investment and intensified inflationary pressures, worsening the growth-inflation tradeoff. Lack of timely policy tightening would exacerbate existing imbalances and weaken confidence in the fiscal framework. External risks are associated with global financial conditions and commodity prices. Over the medium term, a substantial scaling up of investment will be necessary to boost potential growth. Policies. With supply-side constraints restraining short-term growth, a tightening policy stance is needed to rebalance demand, including a steady fiscal consolidation, winding down policy lending, and continued monetary tightening. Strengthening Brazil’s longstanding fiscal framework to rebuild fiscal buffers and bolster confidence would entail adherence to a primary balance that puts gross debt firmly on a downward path; maintaining sub-national fiscal discipline; easing rigidities to increase public saving; and more fully recognizing contingent fiscal risks. The flexible exchange rate remains the main shock absorber for global turbulence, while intervention should aim to limit disorderly market conditions. The renewed focus on supply-side policies is welcome but in order to increase potential growth, decisive and comprehensive efforts are needed to enhance productivity and competitiveness, increase investment, and mobilize domestic saving. July 2, 2013
This year’s capital markets report provides a comprehensive survey of recent developments and trends in the advanced and emerging capital markets, focusing on financial market behavior during the Asian crisis, policy lessons for dealing with volatility in capital flows, banking sector developments in the advanced and emerging markets, initiatives in banking system supervision and regulation, and the financial infrastructure for managing systemic risk in EMU.
“How did the East Asian miracle turn into one of the worst financial crises of the century? A case study of Malaysia provides some answers”–Cover.
The global financial crisis has highlighted the potential of financial conditions for influencing real economic activity. We examine the linkages between the financial and real sectors in the euro area, finding that (i) bank loan supply responds negatively to declines in bank soundness; (ii) a cutback in bank loan supply has a negative impact on economic activity; (iii) a positive shock to the corporate bond spread lowers industrial output; and (iv) risk indicators for the banking, corporate, and public sectors show an improvement beginning in 2002–03, followed by a major deterioration since 2007. These estimates imply that the currently estimated bank losses would subtract some 2 percentage points from the euro area output (but with considerable uncertainty around the estimates).
This paper studies the transmission of bank capital shocks to loan supply in Indonesia. A series of theoretically founded dynamic panel data models are estimated and find nonlinear effects of capital on loan growth: the response of weaker banks to changes in their capital positions is larger than that of stronger banks. This non-linearity implies that not only the level of capital but also its distribution across banks in the financial system affects the transmission of shocks to aggregate lending. Likewise, the effects of bank recapitalization on loan growth depend on banks’ starting capital positions and the size of capital injections.
This paper discusses findings of the Financial System Stability Assessment for Georgia. Georgia has weathered several shocks, but still faces a number of important risks. The economy has withstood well the conflict with Russia, the global financial crisis, and domestic political uncertainty. Significant steps have been taken to strengthen banking regulation and supervision, which exhibit a very high degree of compliance with international standards. The National Bank of Georgia has also introduced an advanced risk-based supervisory regime while maintaining a conservative approach aimed at detecting vulnerabilities at an early stage, and allocating supervisory resources in the most efficient and effective manner.