What are the limits on Commercial Bank Lending?

TL;DR

This paper analyzes the 2007-8 credit crisis by examining banking system mechanics, regulatory failures, and their role in destabilizing credit and money supply growth, leading to systemic risk and increased default potential.

Contribution

It offers a novel explanation for credit crises focusing on regulatory framework failures and their impact on credit and money supply dynamics.

Findings

Regulatory changes allowed securitized lending to bypass controls.

Total bank lending grew faster than the money supply.

This imbalance increased systemic default risk.

Abstract

Analysis of the 2007-8 credit crisis has concentrated on issues of relaxed lending standards, and the perception of irrational behaviour by speculative investors in real estate and other assets. Asset backed securities have been extensively criticised for creating a moral hazard in loan issuance and an associated increase in default risk, by removing the immediate lender's incentive to ensure that the underlying loans could be repaid. However significant monetary issues can accompany any form of increased commercial bank lending, and these appear to have been overlooked by this analysis. In this paper we propose a general explanation for credit crises based on an examination of the mechanics of the banking system, and in particular its internal controls on the supply of credit. We suggest that the current credit crisis is the result of multiple failures in the Basel regulatory framework, including the removal of central bank reserve requirements from some classes of deposit accounts within the banking system, allowing financial instruments representing debt to be used as regulatory capital, and in particular the introduction of securitized lending which effectively removed a previously implicit control over the total quantity of lending originating from the banking system. We further argue that the interaction of these problems has led to a destabilising imbalance between total money and loan supply growth, in that total lending sourced from the commercial bank sector increased at a faster rate than accompanying growth in the money supply. This not only created a multi-decade macro-economic debt spiral, but by increasing the ratio of debt to money within the monetary system acted to increase the risk of loan defaults, and consequentially reduce the overall stability of the banking system.