Credit Conditions and Recoveries from Financial Crises
The prospects for recovery from the 2008 global financial crisis appear to be on the horizon. What determines the path of recovery from a recession associated with a financial crisis? This question is of utmost importance as policymakers debate how soon to withdraw the extraordinary monetary and fiscal stimulus that were put in place soon after the onset of the crisis. This article reviews a recent paper that tackles the issue of recoveries from financial crises.
As the worst of the 2008 global financial crisis appears to be behind us, the focus has shifted to the prospects of recovery. Commentary in the financial press has typically revolved around predicting whether the path of output following the trough of the recession will be U-shaped, V-shaped, W-shaped (a double-dip recession), or L-shaped (a very sluggish recovery).
Recent research at the IMF has examined the patterns of recovery from recessions associated with financial crises in a set of 21 advanced economies (IMF, 2009). The episodes were based on the combination of two databases of banking and financial crises—Reinhart and Rogoff (2008) and Laeven and Valencia (2008)—along with the dating of recession and recovery phases from Claessens, Kose, and Terrones (2009). Recoveries from recessions associated with financial crises were found to be slower relative to a typical recovery. The average time taken for output to return to its previous peak was about six quarters compared to three quarters for all other recoveries. One year after the trough of the recession, the average growth rate of output was only about 2 percent for these episodes compared with an average growth rate of about 4 percent for recessions that were not associated with a financial crisis.
“Policies aimed at recapitalizing financial institutions, resolving distressed financial assets, and ensuring adequate provision of liquidity are crucial to restore the health of the banking system”
One particularly striking finding from this research is that recoveries from recessions associated with financial crises in advanced economies feature a near absence of growth in domestic credit. Credit remains essentially flat even up to two years after the end of the recession, a pattern that is significantly different from all other recovery episodes. Although the demand for credit is generally lower in the aftermath of a financial crisis as households and firms deleverage, stressed credit conditions during these episodes suggest that restrictions in the supply of credit are also important.
Credit conditions become particularly stressed during recessions associated with financial crises due to the occurrence of two distinct events. First, episodes of financial crises are usually accompanied by systemic bank runs, a significant number of bank closures, or a widespread depletion of bank capital, all of which serve to reduce the effectiveness of the financial sector in carrying out its intermediation activities. (See Demirgüç-Kunt and Detragiache, 1998, for more details on the macroeconomic background during banking crises.) Second, the balance sheets of debtors—both households and firms—deteriorate significantly either through bankruptcies, falling asset prices, or failed investments. In the absence of financial frictions, firms should be able to costlessly make up for the decrease in bank credit with other forms of credit, such as debt issuance, leaving investment and output decisions unchanged. The presence of market imperfections, however, implies that these different forms of credit are not perfect substitutes, resulting in higher real costs of credit for firms and industries that are more credit-reliant. Furthermore, any deterioration in the balance sheets of firms also leads to an increase in the cost of external finance due to agency costs (see Bernanke and Gertler, 1989; and Kiyotaki and Moore, 1997).
Kannan (2009) investigates the question of whether or not the stress in credit conditions tends to linger on even after output has started to recover, thus constraining the pace of recovery. Direct measures of credit conditions, however, are difficult to come by. Data on outstanding bank credit conflate supply and demand factors, making identification challenging. Data on bank capital or the net worth of firms would more closely reflect credit conditions, but these are hard to obtain on a systematic basis for a significant cross-section of countries and over a lengthy time period. The paper therefore takes an indirect approach. If credit conditions are important, industries that are more reliant on outside finance, or more subject to financial frictions, should recover relatively slowly following a recession associated with financial crises. Furthermore, as the severity of frictions increases, so should the impact of the dependency on outside finance on growth during recovery.
Kannan (2009) reports that credit conditions play an important role in constraining recovery from recessions associated with financial crises. Industries that rely more on outside finance grow more slowly during recoveries from these episodes relative to all other recoveries, suggesting that credit conditions remain stressed well after the trough of the recession. The effects are strongest during the first year of the recovery phase, and become insignificant only after three years. Importantly, the differential growth pattern across industries with varying dependence on outside finance, which is observed after a recession associated with a financial crisis, is significantly different from the typical behavior during the recovery phase of the business cycle.
Supporting evidence on the importance of credit conditions is obtained by looking at two partitions of the sample along which financial frictions are potentially alleviated: the average degree of tangibility of assets in an industry and the share of industry output that is traded. Industries characterized by a higher degree of tangible assets are in a better position to pledge these assets as collateral and thus reduce the cost of outside finance, while industries that produce goods that are more tradable have an easier time accessing credit from external sources either through trade credits or by pledging export receivables. The paper finds that variation along these two dimensions matters during the recovery phase. Industries that rely more on external finance perform even worse during recovery from a financial crisis when they also have less tangible assets, or produce goods that are relatively less tradable.
Are these effects unique to banking crises? To answer this question, Kannan (2009) considers an alternative definition of a financial crisis. Instead of relying on the crisis dates of Reinhart and Rogoff (2008) and Laeven and Valencia (2008), which feature primarily banking crises, the paper looks at recessions that featured large drops in equity prices. Such episodes are associated with large falls in the net worth of firms, thus raising the cost of outside finance. Just as in the baseline definition of a recession associated with a financial crisis, the results show that industries that rely more on external finance grow more slowly during recoveries from recession episodes that featured large equity price drops. The magnitude of the differential, however, is much smaller, suggesting that the impact of banking crises on credit conditions tends to linger more forcefully than in the case of recessions associated with equity price collapses.
The focus on recoveries following a financial crisis in Kannan (2009) serves as a natural complement to earlier papers that primarily focused on recessions (Braun and Larraine, 2005) and banking crises (Krozner, Klingebiel, and Laeven, 2007; and Dell'Ariccia, Detriagiache, and Rajan, 2008), all of which build on the seminal work of Rajan and Zingales (1998). These papers find evidence that worsening financing conditions intensify the impact on real activity during these episodes. More recently, Tong and Wei (2008) find that the pattern of stock price declines across a broad cross-section of firms, following the onset of the 2007 subprime crisis, indicates that markets were more concerned about the effects of tighter credit conditions on firms rather than any effects due to the expected contraction in demand.1
The findings from this line of research convey an important message regarding the role of policies directed at the financial sector during episodes of financial crises. Policies aimed at recapitalizing financial institutions, resolving distressed financial assets, and ensuring adequate provision of liquidity are crucial to restore the health of the banking system, such that the flow of credit can be resumed quickly. Equally important are policies aimed at improving the balance sheets of nonfinancial firms through expedited bankruptcy procedures, for example. These policies not only ensure a swift return to stability in financial markets and institutions, but also provide a strong foothold for economic recovery.
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ClaessensStijnAyhanKose and MarcoTerrones2009“What Happens During Recessions, Crunches, and Busts?”Economic PolicyVol. 24No. 60 pp. 653–700.
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KannanPrakash2009“Credit Conditions and Recoveries from Recessions Associated with Financial Crises” (unpublished;International Monetary Fund).
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See the June 2009 issue of the IMF Research Bulletin for a review of this paper.