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Credit supply driven boom-bust cycles

Summary:
BIS Working Papers  |  No 885  |  18 September 2020 by  Yavuz Arslan, Bulent Guler and Burhan Kuruscu PDF full text (3,091kb)  |  78 pages Summary Focus The housing market in the US (and in many other countries) experienced a boom-bust cycle during the last two decades. Real house prices increased by more than 30 percent between 1995 and 2006, and then dropped by a similar amount until 2011. The financial sector and the rest of the economy also experienced a boom-bust cycle. This paper studies the role of credit supply in driving these dynamics.

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BIS Working Papers  |  No 885  | 
18 September 2020
PDF full text
 (3,091kb)
 |  78 pages

Summary

Focus

The housing market in the US (and in many other countries) experienced a boom-bust cycle during the last two decades. Real house prices increased by more than 30 percent between 1995 and 2006, and then dropped by a similar amount until 2011. The financial sector and the rest of the economy also experienced a boom-bust cycle. This paper studies the role of credit supply in driving these dynamics. More broadly, we argue that shifts in credit supply can generate large economic fluctuations and can have significant real effects.

Contribution

We develop a quantitative general equilibrium model that combines three sectors of the economy that played critical roles during the boom-bust episode: (i) a rich heterogeneous agent overlapping-generations structure of households who face idiosyncratic income risk and make housing tenure decisions (own, rent, refinance and default), (ii) banks that issue short-term loans to firms and long-term mortgages to households and whose ability to intermediate funds depends on their capital, and (iii) firms that finance part of their wage bill (working capital) through short-term loans from banks. We generate exogenous movements in credit supply by changing the tightness of bank capital constraints, ie leverage, and show that it can generate sizable fluctuations in the housing market and the rest of the economy.

Findings

Reasonable shifts in bank leverage, ie a relaxation followed by reversal, can generate a boom-bust cycle in the economy, similar to the one observed around 2008. The main driver is that the increase credit supply lowers bank lending rate, which, in turn, initiates a boom both directly via lower borrowing costs and indirectly through general equilibrium effects, most importantly wages. The reversal of bank leverage, on the other hand, causes a sharper downturn due to the jump in bank lending rate, as bank net worth contracts sharply.


Abstract

Can shifts in the credit supply generate a boom-bust cycle similar to the one observed in the US around 2008? To answer this question, we develop a general equilibrium model that combines a rich heterogeneous agent overlapping-generations structure of households who make housing tenure decisions and borrow through long-term mortgages, firms that finance their working capital through short-term loans from banks, and banks whose ability to intermediate funds depends on their capital. Using a calibrated version of this framework, we find that shocks to banks' leverage can generate sizable boom-bust cycles in the housing market, the banking sector, and the rest of the macroeconomy, which provides strong support for the credit supply channel. The deterioration of bank balance sheets during the bust, the existence of highly leveraged households, and the general equilibrium feedback from the credit supply to household labor income significantly amplify the bust. Moreover, mortgage credit growth across the income distribution is consistent with recent findings that were otherwise argued to be against the credit supply channel. A comparison of the model outcomes across credit supply, house price expectation, and productivity shocks suggests that housing busts accompanied by severe banking crises are more likely to be generated by credit supply shocks.

JEL codes: E21, E32, E44, E60, G20, G51

Keywords: credit supply, house prices, financial crises, household and bank balance sheets, leverage, foreclosures, mortgage valuations, consumption, and output

International Settlement
The Bank for International Settlements (BIS) is an international company limited by shares owned by central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks". The BIS carries out its work through subcommittees, the secretariats it hosts and through an annual general meeting of all member banks. It also provides banking services, but only to central banks and other international organizations. It is based in Basel, Switzerland, with representative offices in Hong Kong and Mexico City.

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