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Transmission Channels

By Sarah Woo

The BIS folks have just released a literature review about the transmission channels between the financial and real sectors of the economy. This is a pretty comprehensive literature review (which also means that it is a tad dry), but there are interesting bits in their identification of gaps in the literature.

One of the observations in the paper led me to consider a question: is cash-flow based lending or collateral-based lending more susceptible to systemic risk? Which of them serves as a stronger transmission channel for risk between the financial and real sectors? The answer might point the way to better regulation of the financial industry.

As the BIS working group observed, ?[b]orrower balance sheet positions (even without defaults and delinquencies) are relevant to the perceived creditworthiness of borrowers, which in turn influences borrowers? access to credit and their terms on credit, which in turn affects their borrowing and ultimately economic activity.?

Creditworthiness, of course, is not simply influenced by the balance sheet. Let?s think for a bit about how banks think about their borrowers. Lending can be divided into two types: cash-flow based and collateral-based, or asset-based. In the former, a loan is made based on whether the lender believes that the borrower?s assets can generate enough cash to pay off the loan. In the latter, the lender is more concerned with the assets as collateral, and makes the loan at a level of over-collateralization such that the cost of realizing the collateral as well as accrued interest and principal, should the borrower default, can be collected.

The existence of cash flow lending can be proved by the prevalence of unsecured credit such as corporate bonds, just as lenders? over-reliance on collateral (housing) prices prior to the crisis is also well-known. Nonetheless, some might argue that collateral is the foundation of credit, and point to studies showing that the price of credit is directly proportional to the level of collateral and that asset value is based on cash flows (think DCF model). The proper monitoring of the quality of collateral is thus the key to financial stability in the financial and thus real sectors.

Others might point out that excessive focus on market prices of collateral ignores (or even encourages) bubble effects and that a constant evaluation of the income-producing potential of assets, e.g. focusing on the rental income of real estate rather than its market price, would have led to less of a bubble. On a related note, in 2009, financial regulators issued a policy statement exhorting banks to renew or restructure loans with commercial real estate borrowers which are still generating cash flows and have the ability to repay their debts, even if the market value of the underlying collateral has declined to an amount less than the loan balance.

Of course, what we need is more empirical research. But it?s important to understand that these different kinds of lending (and different borrower profiles) can have different implications for risk transmission. For example, in the collateralized world, the real sector transmits risk to the financial sector when collateral values fall suddenly in a market correction, causing the values of loans (defaulted and performing both) to fall and causing undercapitalization of banks. In the cash flow world, it is when incomes and economic activity start falling that cash flow starts to dry up and defaults increase. Reflexively, banks start to discount cash flows more heavily and the risk premium goes up across the market, causing mark-to-market losses for bank?s assets and thus undercapitalization. It may seem like a fine distinction but these are just examples of the kinds of hypothetical mechanisms which we should be investigating (perhaps with data on loans in bankruptcy).

Full post as published by Credit Slips on February 26, 2011 (boomark / email).