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Giving Credit Where Credit is Due: How to Design Policies that Work

What’s up with weak credit? Five years into the economic crisis credit is still barely growing, and even declining in many advanced economies. Weak credit growth is a major factor holding back the economic recovery and governments have tried every policy they can come up with to jumpstart credit. Still, banks don’t seem to want to lend. Or is it the corporate sector and households that can’t afford to borrow? Many feel these policies are not working. What are policymakers to do?

Our analysis in the most recent Global Financial Stability Report tries to shed light on all this darkness to help countries figure out how to make these policies work. It turns out there is no cookie-cutter solution: the problem differs from country to country and changes over time. For example, in a number of euro area countries, a lackluster demand for loans limited credit growth early in the crisis, but then banks became reluctant to supply more loans as the crisis in Europe intensified in 2012.

So what tactic should countries use? Policies are most effective if they correctly target the underlying factors that are constraining credit. So, in those euro area countries in my example, for policies to be effective they should have aimed to support the demand for credit early in the crisis (by say alleviating over-indebtedness in firms and households), and then shifted to support credit supply (for instance, by cleaning up bank balance sheets).

A tough job for policymakers

Such nimbleness in policymaking is always easier said than done. In this case, it is especially tough, since finding the factors underlying credit weakness turns out to be very difficult. We cannot observe these factors directly, and they can affect the demand for and supply of credit in various ways. They also interact with each other, and change over time.

We propose a step-by-step approach to help countries: first, using data from lending surveys, we can try to disentangle general demand and supply factors, arguing that this distinction offers a first cut to target policies, which can differ substantially depending on whether policies target credit supply or demand. A second, more challenging step then tries to pinpoint the specific factors that have been constraining credit growth. We applied this framework to a few countries for which sufficient data are available and found that no two countries’ issues are alike nor are they frozen in time.

For example, we found that in the United States, corporate credit was constrained early in the crisis by a substantial tightening of lending standards in banks, but that these constraints have since dissipated. Supply constraints have more recently resurfaced in some euro-area countries, including France and Italy. These findings provide a handle for policymakers to target their policies.

Restraint is key

Targeting policies is important because the current approach of piling policy upon policy to try to revive credit growth comes with costs and risks. Some of these costs are clear up front, like the fiscal cost of a bank recapitalization. Some can be contingent, like a credit guarantee scheme. Still others are more obscure, like an increased risk to financial stability.

For example, policies that encourage banks to lend to certain sectors (such as lowering prudential risk weights for loans to small and medium-sized enterprises) could increase credit risk in banks, with the potential to inflate nonperforming loans in the future. To make such credit policies work, supervisors are waiving adherence to some of the normal practices that are geared to lessen risks,  since these policies are designed in part exactly to compel banks to take more risk. Thus, the increased risk to financial stability should be seen as a cost of the policies that should be carefully weighed against their benefits.

Indeed, we should consider the possibility that policymakers are trying to do too much. We provide an inventory of the many policies that 42 countries have implemented. It’s a very long list and it is not clear that the net benefits of all policies are favorable. To ensure better outcomes, we recommend that officials collect better data, including matched borrower-lender data on new loans), use the framework developed in the paper to pinpoint the constraints to credit creation on both the demand and the supply sides as they change over time, and apply the results to improve the targeting of credit-supporting policies. Better targeted policies would benefit credit creation at a lower cost to the public purse and to future financial stability.