Category Archives: credit

1/9/19: Priming the Bubble Pump: Extreme Credit Accommodation in the U.S.


Using Chicago Fed National Financial Conditions Credit Subindex (weekly, not seasonally adjusted data), I have plotted credit conditions measurements for expansionary cycles from 1971 through late August 2019. Positive values of the index indicate tightening of credit conditions in the economy, while negative values denote loosening of credit conditions.


Since the start of the 1982 expansionary cycle, every consecutive cycle was associated with sustained, long term loosening of credit conditions, which means the Fed and the regulatory authorities have effectively pumped up credit in the economy during economic expansions - a mark of a pro-cyclical approach to financial policies. This trend became extreme in the last three expansionary cycles, including the current one. In simple terms, credit conditions from the end of the 1990s recession, through today, have been exceptionally accommodating. Not surprisingly, all three expansionary cycles in question have been associated with massive increases in leverage and financialization of the economy, as well as resulting asset bubbles (dot.com bubble in the 1990s, property bubble in the 2000s, and financial assets bubbles in the 2010s).

The current cycle, however, takes this broader trend toward pro-cyclical financial policies to a new level in terms of the duration of accommodation and the fact that it lacks any significant indication of moderation.

12/1/19: Global Liquidity Conditions


Things are getting ugly in the global liquidity environment.

1) The U.S. Treasuries demand from foreign buyers is drifting down - a trend that has been on-going since mid-2016. As of mid-4Q 2018, the combined foreign institutional holdings of U.S. Treasuries was at its lowest levels since the start of 2015.

2) The U.S. Dollar strength is now at its highest levels since early 2002.


Meanwhile, liquidity is falling:

3) Global liquidity supply is turning down, having trended relatively flat since the start of 2015


This is not a good set of signs, especially as this data is not reflecting, yet, the ECB tightening.

12/1/19: Global Liquidity Conditions


Things are getting ugly in the global liquidity environment.

1) The U.S. Treasuries demand from foreign buyers is drifting down - a trend that has been on-going since mid-2016. As of mid-4Q 2018, the combined foreign institutional holdings of U.S. Treasuries was at its lowest levels since the start of 2015.

2) The U.S. Dollar strength is now at its highest levels since early 2002.


Meanwhile, liquidity is falling:

3) Global liquidity supply is turning down, having trended relatively flat since the start of 2015


This is not a good set of signs, especially as this data is not reflecting, yet, the ECB tightening.

2/9/16: Does bank competition reduce cost of credit?


In the wake of the Global Financial Crisis, there has been quite a debate about the virtues and the peril of competitive pressures in the banking sector. In a paper, published few years back in the Comparative Economic Studies (Vol. 56, Issue 2, pp. 295-312, 2014 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2329815), myself, Charles Larkin and Brian Lucey have touched upon some of the aspects of this debate.

There are, broadly-speaking two schools of thought on this subject:

  1. The market power hypothesis - implying a negative relationship between bank competition and the cost of credit (as greater competition reduces the market power of banks and induces more competitive pricing of loans). This argument is advanced by those who believe that harmful levels of competition can lead to banks mispricing risk while competing with each other. 
  2. The information hypothesis postulates a positive link between credit cost and competition, as the banks may be facing an incentive to invest in soft information. 


Now, a recent paper from the Bank of Finland, titled “Does bank competition reduce cost of credit? Cross-country evidence from Europe” (authored by Zuzana Fungáčová, Anastasiya Shamshur and Laurent Weill, BOFIT Discussion Papers 6/2016, 30.3.2016) looks at the subject in depth.

Per authors, “despite the extensive debate on the effects of bank competition, only a handful of single-country studies deal with the impact of bank competition on the cost of credit. We contribute to the literature by investigating the impact of bank competition on the cost of credit in a cross-country setting.” The authors take a panel of companies across 20 European countries “covering the period 2001–2011” and study “a broad set of measures of bank competition, including two structural measures (Herfindahl-Hirschman index and CR5), and two non-structural indicators (Lerner index and H-statistic).”


The findings are interesting:

  • “bank competition increases the cost of credit and …the positive influence of bank competition is stronger for smaller companies”
  • These results confirm “the information hypothesis, whereby a lack of competition incentivizes banks to invest in soft information and conversely increased competition raises the cost of credit.” 
  • “The positive impact of bank competition is influenced by two additional characteristics. It is lower during periods of crisis, and the institutional and economic framework influences the relation between competition and the cost of credit.”
  • Overall, however, the “positive impact of bank competition is …influenced by the institutional and economic framework, as well as by the crisis.”


The authors ‘take-away lesson” for policymakers is that “pro-competitive policies in the banking industry can have detrimental effects, … [and] banking competition can have a detrimental influence on financial stability and bank efficiency.”

I disagree. Judging by the above, higher costs of credit overall, and higher costs of credit for smaller firms, may be exactly what is needed to induce greater efficiency and reduce harmful distortions from over-lending. As long as these higher costs reflect actual risk levels.

2/9/16: Interest Rates, Financial Cycles and the Real Economy


Claudio Borio and his team at the Bank for International Settlements have just published another interesting working paper, titled “Monetary policy, the financial cycle and ultra-low interest rates” (BIS Working Papers No 569 by Mikael Juselius, Claudio Borio, Piti Disyatat and Mathias Drehmann Monetary and Economic Department July 2016).


In the paper, the authors ask whether “the prevailing unusually and persistently low real interest rates reflect a decline in the natural rate of interest as commonly thought?”

The authors “argue that this is only part of the story. The critical role of financial factors in influencing medium-term economic fluctuations must also be taken into account.” In other words, the authors attempt to control for purely financial factors driving interest rates first, and then consider predominantly real economic variables-determined rates (natural rates).

You might think that the currently low rates are facilitating the real economy, right? If so, then actual observed (already low) rates today should be coincident with even lower ‘natural’ rates (if real economy drags down the financial economy). Alas, as the authors find: accounting for the different sources of pressure on the interest rates (financial vs natural), in the case of the United States, “yields estimates of the natural rate that are higher and, at least since 2000, decline by less.”

Oops… so persistently low interest rates today are below natural rates and reflect the needs of the financial intermediation sector.


Notice the difference between the observed rates (yellow) and the ‘natural rates’ (red). Or as the lads from BIS put it: “As a result, policy rates have been persistently and systematically below this measure.”

But never mind. With time, things should get rebalanced, as the authors also find that “monetary policy, through the financial cycle, has a long-lasting impact on output and, by implication, on real interest rates. Therefore, a narrative that attributes the decline in real rates primarily to an exogenous fall in the natural rate is incomplete. The influence of monetary and financial factors should not be ignored. Exploiting these results, an illustrative counterfactual experiment suggests that a monetary policy rule that takes financial developments systematically into account during both good and bad times could help dampen the financial cycle, leading to higher output even in the long run.”

Yah, yah… lots of talk. What’s the meaning? Ok, the authors take two drivers of financial sector impact on the real economy: leverage and credit.


Leverage gap is defined as basically a credit to assets ratio for the economy - or how much credit does economy create per each unit of assets. Meanwhile debt service gap is the ratio of debt service payment, or more precisely, “the ratio of interest payments plus amortisations to income”.

To understand the dynamics of the monetary (interest rates) policy impact, the authors do a couple of experiments. The main one is worth discussing. The authors start with a leverage gap of -10%, so there is an excess of assets over credit in the economy and hence there is room to borrow, driving leverage gap up. Note: as the authors point out, the -10% leverage gap assumption is consistent with historical reality: in the late 80s and mid-2000s, “at their trough”, leverage gaps were -11% in 1987 and -20% in 2006 respectively.

So, as I noted above, “a negative leverage gap initially induces a credit boom that then turns into a bust… Initially, the negative leverage gap is followed by rapid credit growth, which in turn feeds into a positive, albeit small, increase in private sector expenditure. But as credit outgrows output, the credit-to-GDP ratio and with it the debt service gap start to rise, putting an increasing drag on output and asset prices. A severe and drawn-out recession follows.”

The dynamics match the Great Recession: “…at the start of 2005, the real-time estimate of the leverage gap was significantly negative while the debt-service gap was positive. Given this starting point, the adjustment dynamics of the system would have predicted much of the subsequent output decline during the Great Recession. This suggests that the recession was not a “black swan” caused by an exogenous shock but, rather, the outcome of the endogenous dynamics of the system – a reflection of the interaction between the financial factors and the
real economy.”

And here is the actual run of annual estimates of the two gaps:


Remember, the cyclicality? Negative leverage gap —> credit boom —> positive leverage gap and positive debt service gap —> bust.

Good thing we are not going to repeat THAT cycle this time around, right?.. Not with all the low interest rates not being lower than ‘natural’ rate… right?