The Impact of Flight to Quality on Bank Lending

John Cochrane's paper on run-free banking, which I mentioned in my last post, includes a section discussing why financial crises have real effects.  It's an important question.  Understanding why a fall in the value of securities or a bank run might lead to a reduction in output should shape how we think about financial regulation.[1]

One of the main features of the recent crisis was the flight to quality, in which investors sought to sell privately issued asset-backed securities in favour of government paper.  The simple story here then might be that the fall in demand for private paper reduces the price and raised the yield. This raised the cost of borrowing for new borrowers wanting to access this market.  Faced with this higher effective interest rate, private agents looked to defer spending.

It's a reasonable story and no doubt has an element of truth.  However, I think it misses some important features of the way things work in practice.

Much of the flight to quality of the recent crisis involved short-term investors refusing to take private long-term securities as collateral for short term investment.  This had two important implications for banks.  First, banks were effectively underwriting the liquidity of these securities, so that when the collateral based funding dried up, the banks had to take them onto their balance sheet.  Secondly, the problems with financing the securities caused holders to try to offload them leading to big falls in the market value.  Many banks were heavily exposed to this and took significant losses, eating into their capital base.

So banks suffered a fall in capital at the same time as they were being forced to increase their holdings of assets.  Banks were also having to reassign positions from the trading book to the banking book, due to the increasing illiquidity of those positions, putting further pressure on capital.

In the short run, capital represents an important constraint on bank lending.  In theory, it should be just a question of price.  If the bank needs more capital to lend, it simply charges the borrower the amount needed to cover the cost of the additional capital.  In practice, capital is not something that can be turned on like a tap.  Banks normally rely heavily on retained earnings to provide capital growth.  Although they can do equity issues if needed, capital is inherently long term and paying a high long term price may not be appropriate to deal with a shorter term problem.  So one implication to the flight to quality was a big reduction in bank lending capacity.

Another issue is that a willingness to hold loans at a particular price is not indicative of a willingness to advance new loans at that price.  Banks may be prepared to hang on to distressed loans, rather than sell them at the prevailing market price, because they expect the effective return at that price to outweigh realised losses.  This implies that were they to make new loans at a comparable rate, the profit on the good loans would cover the expected level of defaults. 

However, simply because a strategy might appear to be profitable does not mean a bank will want to pursue it.  Banks may be concerned that undertaking what is apparently riskier lending will cause concern with the shareholders, even if such a tactic could be very profitable.  Things like strategy and focus play an important role in shaping behaviour, not just profit maximisation.  Of course, this may leave the market open to new lenders who are prepared to run higher loss levels, but it can take a long time for this to happen.

The point about factors such as these is that the flight to quality is not just about an increase in the rate at which the private sector can borrow.  In fact, for many people, it means that they can no longer borrow at any price.  The fall in lending played an important role in transmitting the effects of the financial crisis to the real economy, but the quantity response needs to be analysed independently of the price response.  

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[1] The analysis here is not intended to be the same as Cochrane's, nor to necessarily contradict what he is saying.