Often one comes across a research paper that seems to state the obvious and yet makes for fascinating reading. A recent draft paper by Carlson, Lewis and King* (Board of Governors of the Federal Reserve) is particularly instructive as it brings together the linkages between distress in the financial sector and economic activity, a must-read in these turbulent times. The arguments are clear — by facilitating funds flow from investors to borrowers, financial institutions are key contributors to economic growth. It follows that any deterioration in the health and solvency of financial institutions will disrupt economic activity. In traditional financial accelerator models, shocks to the system stem from the condition of the borrowing firms, the creditworthiness, and financial institutions play a passive but crucial role. But in the Carlson-Lewis- King framework, financial institutions themselves can disrupt the system.
Since financial institutions also depend on debt financing, in bad times, their borrowing costs are raised, which they pass on to the borrowing firms. This reduces investment opportunities, even for ‘borrowers of unchanged quality’. The qualification is important as it shows that production is affected even for fundamentally good firms, when the problem originates in the financial sector. In fact, this is the real cause for concern in the manufacturing world today. Investment planning has become shaky even as firms are grappling with meeting current obligations.
What the paper does is to create an index of financial sector health, a distance to default measure, and use this on data from 1973. Their sample takes the 25 largest financial institutions in the US, including investment banks and commercial banks (but does not include government-sponsored Fannie Mae and Freddie Mac). The measure shows stress points in 1974, 1987, early 1990s, 1998 — all associated with events of financial institution concerns. While health picked up again in 2003, the index shows a declining trend again since 2006. Testing for the impact on the real economy, they find that each of these stress points is associated with tightening of bank lending standards, significant downturn in investment activity and reduction in profits. One of their most important results is that they look into the amplifying impact of financial sector health on a shock that originates in the non-financial sector. Profits slow down but return to normal in two quarters, but investment remains depressed for up to two years after the shock. There are two channels of the impact on investment growth — one operating through lower profits affecting the cash flow, and one through tight credit.
These two channels have been isolated in the exercise to show that without the second, the impact on investment of lower profits is halved in magnitude and in duration. So, the worsening health of the financial sector amplifies shocks across the economy.
The paper’s data stops at the fourth quarter of 2007 and the measure of financial health would clearly have plummeted since. The impact is already being felt. A Reuters report quotes businessmen in the US, some whose credit lines have been shut down completely, and others who still have access to money but who have had to make changes in their businesses and debt loads to suit their lenders. Standards have become more stringent.
While business is grinding to a halt in America and investment is set to remain depressed for another couple of years, the general consensus is that there will only be a ripple effect of the global crisis in India, not a tsunami hitting our shores. Yet there are already firms out here who are complaining of being shut out from credit. Clearly investment will be hit down the line. And then there are more domestic concerns coming in from the exchange rate, inflation and reserve requirements fronts — all adding fuel to a cauldron that is bubbling with trouble.
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How long will this last and how bad will it be? Though the paper does not attempt any sort of prediction for the health of the financial sector, for firms struggling with a credit crunch and investment blues, this would be the question uppermost in their minds. Prediction, of course, is a different ball game.
The author is Chief Economist at Indicus Analytics and can be contacted at sumita@indicus.net
* http://www.federalreserve.gov/Pubs/feds/2008/200843/200843pap.pdf