OF SUBSTANCE AND SPIRIT
The broadsheets recently reported that the uncertainty of the pandemic-induced economic fallout led banks to tighten their lending policies. Extracted from the BSP’s own quarterly survey of senior bank loan officers for Q3 2020, the bad news was that most respondent banks intended to keep their lending standards strict. Worse, a large percentage also expected to tighten further their loan criteria due to “a more uncertain economic outlook along with expected deterioration in borrowers’ profiles and profitability of banks’ portfolios, including banks’ lower tolerance for risks.”
While the BSP in its own press release claimed that fewer banks implemented tighter credit standards, the results illustrate that the banks chose to be procyclical in their lending operations.
So, what is wrong if the banks decide to lean with the business cycle?
Nothing except that if this predictable response of banks to the deepest recession in decades gathers momentum, economic recovery might instead be prolonged.
With tight lending standards, it is not surprising that for July and August, 2020, total bank loans net of their investment in BSP debt instruments, loan growth further slowed down year-on-year from 6.7 percent in July, 2020, to 4.7 percent in August, 2020. What should concern us even more is the actual month-on-month seasonally adjusted 1.1 percent decline in bank loan growth for August relative to July’s.
Loan growth for production activities decelerated from 5.9 percent in July to 4.2 percent in August. Household credit extended through credit cards, for motor vehicles and for general purposes barely rose. Growth slowed down from 17.2 percent in July to only 12.9 percent in August.
Since procyclicality of banking means that financial developments could shape macroeconomic outcome, reducing bank exposure to both the production sector and households during this recessionary period could reinforce the underlying downturn in economic activity. It could drive extreme swings in business activities that have been used to enjoy credit support from their friendly banks.
With the pandemic, banks may find it difficult to figure out how the recession could actually affect the credit profile of their corporate and individual borrowers. Whatever information they have from the usual due diligence of credit investigation, or intelligence from the credit bureau could be clouded by information asymmetry. Only the borrowers would have complete information about their financial prospect, or lack of it.
During this economic contraction and shrinking demand for credit, even excellent borrowers may find it difficult to source funding. Banks, supported by their respective risk management units, may have all the reasons to tighten their credit standards to avoid bad credits and ultimate defaults.
By being pro-cyclical, banks could be hindering what the central bank is trying to do. The BSP has claimed publicly that it has unleashed an equivalent of P1.8 trillion in additional liquidity while reducing its policy rate to a level lower than actual and projected inflation for 2020 and 2021. This is all for nothing if the banks remain reluctant to expand their loan portfolio.
To cushion their bottom lines and balance sheets, banks have also decided to simply park their funds with the BSP, even those released by the BSP itself following the reduction in the required reserve ratios (RRR), rather than lend out with blinders. During recession when nobody wants more exposure, lending to BSP is zero risk.
This is where we were coming from when we wrote many times in the past that weak confidence in our economic future due to our serious deficit in public health care cannot be solved by more and more monetary easing.
That is how central banks end up pushing on a string. But this is not the way to pursue what Minsky described as the role of central banking: “stabilizing an unstable economy.”
Instability also derives from market participants’ inappropriate response to economic recession of this magnitude. In economic downturns, it is possible for market participants to over estimate risks. Procyclicality sets in again when banks attempt to address impending risk by increasing their loan loss provisioning. This further takes away funds from their loan window. This is good risk management but higher provisioning in a down cycle may be counter-intuitive. Setting aside reserves should normally be undertaken during good times.
Otherwise, with tighter credit standards and loanable funds parked with the BSP, higher loan loss provisioning could further add to the worsening and duration of economic contraction.
It is the banking system’s appreciation of the so-called time dimension of risk that should anchor their credit decision and avoid being pro-cyclical. It is easy to talk about absolute risk of each corporate or individual client. Risk ratings are normally established by the credit department of the bank and in the case of big exposures, the board makes the final decision. But during a downswing like what we are facing today, what is more relevant is the relative risks which evolve from the correlation of credit losses among the borrowers and the probability of default. Correlation is heightened during this pandemic because everyone is affected.
But credit compression is not the answer. It is the banks’ more enlightened risk management practices. It is regulatory policies that are not contingent on the cycle. It is being counter-cyclical to mitigate financial imbalances.
Today, we rise and fall with our authorities’ ability to manage the virus and flatten the curve. If they are successful, confidence will be restored. Fiscal policy can do heavier lifting while the banks should extend more, rather than less, credit to the real economy. With this state of affairs, banks can choose not to tighten their functioning credit standards and help monetary policy achieve its goal of stimulating domestic demand while maintaining financial and price stability.
In previous columns, we also wrote about hysteresis. This is all about those long-lasting economic scars that could delay the resumption of growth. The IMF talks about them in terms of “weaker productivity growth, heavier debt burdens, heightened financial vulnerabilities and higher poverty and inequality.”
Fiscal policy and monetary policy are fighting this severe downcycle. Banks can choose not to be pro-cyclical and become part of the solution.As Bill George and Peter Sims would have put it, it’s about time we found our true north, our orienting point.