The Credit Channel at Work: Lessons from the Republic of Korea's Financial Crisis

25 Pages Posted: 20 Apr 2016

Date Written: September 1999

Abstract

When negative monetary and financial shocks hit the Korean economy, reactions in the financial system amplified the impact of the shocks by reducing the credit available and increasing its cost. This particularly hurt segments of the economy that rely heavily on bank credit for external financing, such as small and medium-sized enterprises.

Ferri and Kang suggest that the credit channel - as a transmitter of monetary and financial shocks - appears to have aggravated the Republic of Korea's economic crisis.

They use microdata gathered at the bank level to better identify this channel of transmission. They find that:

* Monetary tightening broadens the spread between marginal bank lending rates and corporate commercial paper rates (consistent with the hypothesis that bank lending is a transmitter of monetary shocks). * Credit limits on overdrafts - arguably a proxy to identify shifts in the loan supply - react negatively to the monetary squeeze. * After the stiffening of bank capital adequacy requirements, banks suffering from larger negative capital shocks experience a more marked slowdown in lending and deposit-taking and also raise their loan rates disproportionately.

These findings lend support to the hypothesis that autonomous contraction by banks restricts the availability of credit and magnifies the increase in its cost. This phenomenon compounded the Korean crisis by aggravating liquidity constraints for most agents that rely on bank credit as their only external source of funds.

Policymakers may want to provide relief - possibly through market-based actions - to the small and medium-sized enterprises (and other businesses) that suffer unduly from such a credit crunch. To reduce obstacles to recovery, they may also want to devise market-based incentives to make bank loans available to healthy firms in sectors (such as exports) on which recovery depends.

This paper - a product of the Financial Sector Development Unit, East Asia and Pacific Region, and Finance, Development Research Group - is part of a larger effort in the Bank to study the credit crunch in East Asia.

Suggested Citation

Ferri, Giovanni and Kang, Tae Soo, The Credit Channel at Work: Lessons from the Republic of Korea's Financial Crisis (September 1999). World Bank Policy Research Working Paper No. 2190. Available at SSRN: https://ssrn.com/abstract=623961

Giovanni Ferri (Contact Author)

LUMSA University ( email )

Via della Traspontina
Roma, Rome 00192
Italy

HOME PAGE: http://www.lumsa.it/giovanni-ferri

Tae Soo Kang

World Bank ( email )

1818 H Street, N.W.
Washington, DC 20433
United States

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