Academic journal article Journal of Money, Credit & Banking

The Capital Crunch: Neither a Borrower nor a Lender Be

Academic journal article Journal of Money, Credit & Banking

The Capital Crunch: Neither a Borrower nor a Lender Be

Article excerpt

THE DRAMATIC REDUCTION in the growth rate of bank lending associated with the 1990-91 recession, particularly in New England, has evoked claims by many observers of a credit crunch. Skeptics argue, however, that weak loan growth merely reflects the normal procyclical pattern of both loan demand and the creditworthiness of borrowers. Thus, the view that a downward shift in credit supply precipitated, or at least worsened, the economic downturn remains quite controversial. Because of the difficulty in determining whether the observed slow credit growth is a demand or supply phenomenon, convincing evidence of the practical importance of credit crunches remains elusive.

Unlike previous periods where credit availability was tied to episodes of disintermediation (Wojnilower 1980), the current period of reduced credit coincides with banks having difficulty meeting minimum capital requirements. Therefore, "capital crunch" better describes the current problem, whereby a decline in capital causes a bank to shrink.(1) Banks facing binding capital constraints as a result of large loan losses and low or no earnings have only two options for raising their capital/asset ratios: raise new capital or shrink both assets and liabilities. A major reason for banks to choose to shrink rather than to issue new equity may be asymmetric information and the lemons problem (Myers and Majluf 1984). Because managers have no incentive to disclose problems in their asset portfolio, potential equity holders, concerned that only problem banks would be willing to dilute the shares of current equity owners, refuse to buy new stock issues at a price providing "normal" economic returns. Thus, new equity cannot be issued at a price that management and current shareholders deem reasonable, leaving shrinkage as the only feasible alternative. In fact, in our sample of New England banks many have chosen to shrink.

For problems in the banking sector to extend to the real economy, banks must provide a service that is not easily provided by alternative financial intermediaries. Banks specialize in financing small and medium-sized businesses, where most information is private rather than public; where knowledge of the industry, management skills, and local conditions may be critical to the determination of credit-worthiness; and where lending institutions can achieve economies of scope in monitoring the borrower. Because of this asymmetry in information, most small and medium-sized businesses find banks the only economical source of debt financing. (See, for example, Elliehausen and Wolken 1990; and Gertler and Gilchrist 1994.)

The purpose of this paper is to document that the recent reduction in bank capital has caused New England banks to contract, that is, supply has played an independent role in the recent decline in bank credit. Losses of bank capital can cause banks to shrink to restore target capital/asset ratios in response to regulatory pressures, financial market pressures, or the tastes and preferences of bank management (Hancock and Wilcox 1992). While the exact source of the supply effect is difficult to disentangle, the increased attention to capital regulation is a major reason why the supply effect may be more pronounced now than in the past. Our theoretical model emphasizes the direct regulatory link by deriving the impact of binding capital regulations on bank behavior. Then, controlling for demand, we find empirical evidence supporting the hypothesis that New England banks have experienced a capital crunch. If asymmetric information is important and if the costs of acquiring information and monitoring loans are large, then a capital crunch may cause a decline in lending that is not filled by other lenders, that is, a credit crunch.

The first section of this paper provides a theoretical model, which verifies that a loss of bank capital resulting in binding capital requirements will cause a bank to behave differently than it would if the requirements were not binding. …

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