Credit Demand and Supply: A Two-Way Feedback Relation

Abstract

The model developed in this paper extends the framework of self-fulfilling credit market freezes proposed by Bebchuk and Goldstein (2011) by endogenizing firms' investments decisions. The existence of an aggregate investment threshold below which individual investment projects are unsuccessful creates a coordination failure not only among banks but also among firms and, crucially, between the two sides of the market. Because of the resulting strategic complementarities between firms and banks, low credit demand expectations reduce credit supply and viceversa. This two-way feedback loop explains why a severe slump in aggregate demand may be associated with a disruption in lending caused by a financial crisis. Replies to the euro area Bank Lending Survey by individual Italian banks provide support to the model's conclusions.

The (Unobservable) Value of Central Bank's Refinancing Operations

“…As expected, we find a negative demand elasticity for loans, with NFCs being more sensitive than households, and find that borrowers' expected default rates are increasing in loan interest rates, consistent with evidence of either adverse selection or moral hazard. In line with recent work (Ippolito, Peydró, Polo & Sette 2016, Altavilla, Boucinha, Holton & Ongena 2019, Albertazzi & Esposito 2017, we find that loan demand is decreasing in bank's default risk, even though to a lesser extent than uninsured deposits' demand.…”

Policy Mix During a Pandemic Crisis: A Review of the Debate on Monetary and Fiscal Responses and the Legacy for the Future

“…While wealthy households may decide to rebalance their portfolios towards more liquid assets, poorer households and SMEs' deposits may fall reflecting their liquidity constraints. 36 In particular, spirals may stem from the presence of strategic complementarities between borrowing and lending decisions (Albertazzi and Esposito, 2017). These complementarities may weaken considerably credit dynamics generating a self-fulfilling loop in which the weakest side of the credit market creates a persistent demand/supply shortage.…”

Policy Mix During a Pandemic Crisis: A Review of the Debate on Monetary and Fiscal Responses and the Legacy for the Future

“…Retail funding could also record a halt. While wealthy households may decide to rebalance their portfolios towards more liquid assets, poorer households and SMEs' deposits may fall reflecting their liquidity constraints.36 In particular, spirals may stem from the presence of strategic complementarities between borrowing and lending decisions(Albertazzi and Esposito, 2017). These complementarities may weaken considerably credit dynamics generating a self-fulfilling loop in which the weakest side of the credit market creates a persistent demand/supply shortage.…”