Current arguments that we may see a slowdown in the economy caused by an old fashion credit crunch are right on the mark. But first we have to define terms. A credit crunch is caused by growing conservative lending policies during periods of financial duress and reduced profitability. If there are higher risks from lending, reduce the amount (quantity) of lending that is being done. If the changes in risks are swift, there is a crunch. A credit crunch may not be solved with lower interest rates. There is a distinction between a credit crunch and a liquidity crisis. Monetary policy may not be effective for a credit crunch. It will is more likley to be effective with a liquidity crisis.
The world has radically changed since the last credit crunch in the early 1990's, but it has not all been for the worst. First, the bad news on the credit market changes. One key finding of the credit cycle work is the value of relationship banking. When the bank knows its customers and can reduce moral hazard and adverse selection problems, there is an opportunity to avert some of the potential problems from changing credit quality. The relationship banking model allows the lender to understand the business of the borrower and hopefully make more nuanced decisions on how to extend credit. Credit will be shut for the marginal borrower and for the borrower that does not have a long history with the lender. When assets are securitized there is a break in the link or relationship between lender and borrower. Detailed information on the history of the borrower is not as readily available. There is greater likelihood that the lender will walk away from the borrowed in situations where there is not good information on the collateral or borrower and there is no long-term relationship.
Now, the good news since the last credit crunch. The advantage of securitization is that the pool of potential lenders or buyers of debt are much greater. At the appropriate price there can be found buyers where otherwise it would not be the case if the information on the borrower was limited and the relationship was with one institution. Lending information can be sold to a broader market than the local bank. Lending risks will not be localized. There can be significant gains from diversification. In a securitized world, there is a greater chance that new lender will step in at the right price. This expands the potential pool of credit.
Securitization is not without problems. Selling off loans to third parties divorces the initial lender from the risk of default. This environment creates disincentives to find only quality loans. If you get paid on the flow of loans and no the ultimate payment of loans, you will just write more loans without regard for high standards. You write to the lowest standards in the market. It is up to the buyer of the loans and rating agencies to set the standards, yet they may not have the expertise in this area. (When I was in banking back in the early 1990’s, it was informative going on a trip with bank loan underwriters. Seeing collateral makes a big impact on lending standards.) Securitization changes the incentives for bankers. They are not holding debt but become as quoted by Minsky, ‘merchants of debt”.
Going back to the old relationship banking may be difficult, but it will clearly happen through market forces. Securitization will be more difficult and rates will rise. This will make holding loans more profitable. The market will adapt, but currently, we do not have a historical precedent for this credit crunch.
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