Unfreezing Credit Markets

Abstract

Despite the large infusion of capital into the financial sector and low interest rates, the flow of financing to operating firms has failed to return to normal levels. One explanation suggested is that banks still lack confidence because they need time to adjust to the new environment. Another is that the reduced flow of credit reflects banks' rational assessment of borrowers' bleak prospects in the current economic conditions. This paper puts forward a third explanation. When the prospects of operating firms are interdependent, banks' decisions on whether to lend to a given operating firm depend on their expectations about whether other operating firms will receive financing. As a result, an inefficient credit market freeze may arise in which banks avoid lending to operating firms due to their self-fulfilling expectations that other banks will not be lending. Such an inefficient freeze may persist even when banks have ample capital and interest rates are brought down to a barely positive level.

Facing an inefficient and persistent credit freeze, I argue, the government should consider getting the economy out of it by taking upon itself the credit risks involved in providing a substantial amount of new lending to operating firms. This can be accomplished by (i) providing banks with non-recourse financing for portfolios of new loans to operating firms, or otherwise agreeing to bear part of the risks generated by such portfolios, in return for a share of the upside, or (ii) setting up government-funded, privately managed funds dedicated to making such loans. These mechanisms funds can contribute substantially, both directly and indirectly, to producing a credit thaw.
A model for studying credit freezes and alternative government responses to them is developed in Bebchuk and Goldstein, Self-fulfilling Credit Market Freezes, available at: http://papers.ssrn.com/abstract=1315462

Keywords: Credit freeze, credit crunch, credit thaw, financial crisis, self-fulfilling crisis, banks, financial institutions, run on the bank, coordination failure

JEL Classification: D21, E44, E50, E58, E62, G18, G21, G28, H50, P11