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How does the composition of lenders and their willingness to provide credit shape the relationship between credit expansions, real economic activity, and the likelihood of financial crises?

The views expressed herein are solely those of the authors and do not necessarily represent the views of the Federal Reserve Bank of New York.

Image courtesy of interviewee. October 16, 2024

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This video discusses a study on credit cycles, focusing on the dynamics between borrowers and lenders in the credit market for non-financial firms, especially in the wake of the financial crisis. It highlights a renewed interest in understanding credit cycles due to past crises, noting that rapid credit expansions often precede negative economic outcomes, including lower GDP growth and a higher likelihood of financial crises.

The study emphasizes the importance of distinguishing between lenders, specifically comparing credit cycles financed by banking institutions versus those financed by non-bank entities. It posits that non-bank institutions may have fewer negative impacts associated with rapid credit changes. The research also delves into how different types of financial institutions have varied business models, motivations, and preferences regarding the credit instruments they issue or hold (e.g., loans vs. bonds, and the maturities of these financial products).

The authors utilize flow of funds datasets from nine advanced economies, incorporating "who-to-who accounts," to analyze the flow of credit to understand how supplier composition influences total credit and borrowing practices of the non-financial sector. They find that changes in interest rates, the size of the banking sector, and borrower preferences account for variations in credit distribution.

The study concludes that a deeper understanding of credit supply mechanisms and how they relate to future economic conditions is crucial. It also suggests that future research should consider firm-level data to better analyze the impact of different loan structures and lender types on credit outcomes and overall economic performance.

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Here are 5 key points from the video:

1. **Renewed Interest Post-Financial Crisis**: The financial crisis sparked a renewed academic focus on credit cycles, particularly how credit crises can have adverse effects on the real economy, benefiting from historical literature on the subject from the 1970s and 1980s.

2. **Different Lender Types Affect Credit Cycles**: The study emphasizes that credit cycles differ significantly based on whether they are financed by banking institutions or non-bank financial institutions. Non-bank institutions tend to create fewer negative outcomes in credit cycles compared to traditional banks.

3. **Understanding Credit Flow and Financial Composition**: The research aims to study how different types of lenders and their compositions across countries affect credit supply to non-financial firms, highlighting the distinct roles that domestic and external financial sectors play in credit cycles.

4. **Data Collection and Methodology**: The research employs a comprehensive data approach, utilizing "who-to-who" accounts to gain insights into the ultimate recipients of credit and analyzing factors influencing the pricing of credit at the individual instrument level.

5. **Future Research Directions**: The study identifies the need for future research using micro-level data to understand individual firms’ balance sheets and their credit management strategies, which is crucial for examining how the supply of credit influences future real economic outcomes following credit expansions.

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Here are some key quotes extracted from the video you , which summarize the main points:

1. **Renewed Interest in Credit Cycles**: "There was a large literature in the seventies and eighties trying to think about the consequences of credit crisis and where credit crisis can arise from with the financial crisis... we saw a renewed interest in that work."

2. **Study Focus**: "What that post-crisis work found was that adverse real outcomes... we're actually trying to think more holistically about where credit to non-financial firms arises from."

3. **Credit Cycle Differences**: "From a very big picture perspective... credit cycles financed by banking institutions are going to look very different from credit cycles financed by non-bank institutions."

4. **Impact of Credit Expansion**: "Credit expansions, even though they help finance growth in the short run, they tend to lead to negative real outcomes in the longer run... a rapid credit expansion tends to predict a higher probability of banking crisis and financial crisis."

5. **Focus on Lenders**: "...instead of focusing on different borrowers, we're going to be focusing on different lenders in the broader convideo."

6. **Data Collection**: "That required us to put together a few data sets from the perspective of understanding where the credit is being financed... we're going to think separately about banking institutions, insurance companies, pension funds, mutual funds, and other types of financial institutions."

7. **Who to Who Accounts**: "We actually collected what are called who to who accounts... you actually know what is the receiving sector of the credit ."

8. **Different Financial Institutions**: "Different types of financial institutions fundamentally have very different business models... that translates into different financial institutions being interested in holding different types of instruments."

9. **Borrower Preferences**: "Borrowers face the choice between funding themselves through loans or bonds... those distinctions translate into different properties from the perspective of the borrower."

10. **Factors Affecting Credit Composition**: "About a third of the variation is accounted for by the level of interest rates in the economy... the final third is going to be accounted for by the preferences of the borrowers."

11. **Non-Bank Institutions**: "Not all non-bank financial institutions are the same... some types of financial institutions act much more similarly to the traditional banking sector."

12. **Future Research Directions**: "One of the important directions for future research is to try to use micro data to actually study these questions... we think it's important to understand that firms actively manage the composition of their debt."

These quotes capture the essence of the research and interactions within credit markets as discussed in the video.

X-TIMESTAMP-MAP=LOCAL:00:00:00.000,MPEGTS:90000

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This work was,

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the renewed interest in understanding credit cycles,

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that we saw after the financial crisis.

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So, of course, even though, there was a,

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large literature in the seventies

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and eighties trying to think about the consequences

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of credit crisis and where credit crisis, can arise from

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with the financial crisis with,

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we saw a renewed interest in that work.

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What that, post-crisis work found was that,

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rapid expansions of credit tend to be followed by,

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adverse real outcomes.

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What we're doing in our study is actually trying to think,

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more holistically about where credit to non-financial,

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arises from.

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And so in particular, we're interested

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in studying the interactions between borrowers

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and lenders in, the credit market

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for non-financial firms.

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Um, and, one of the things that we find is

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that it's important to actually think about

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who the lenders are

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that are providing credit in the economy.

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And so from a very big picture perspective, one

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of the things that we show upfront is that,

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credit cycles financed by, banking institutions

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are going to look very different from credit cycles financed

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by non-bank institutions.

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For example, the credit cycles finance

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by non-banking institutions are potentially going

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to have fewer of the negative real effects that,

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other pa that other papers have found for credit cycles.

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In general. The literature, that has focused on trying

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to understand how, the effects

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that credit cycles have on future activity

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has found, two things.

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The first is that credit expansions,

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even though they help finance growth in the short run,

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they tend to lead to,

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negative real outcomes in the longer run.

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So at the, around the five year horizon, let's say,

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since the start of the credit expansion.

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And at the same time, a rapid credit expansion tends

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to predict a higher probability of, banking crisis

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and financial crisis.

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So what that means is that when,

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credit is expanding rapidly in the economy,

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there is a higher likelihood of, that credit

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expansion than turning into a credit contraction,

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which then is going to correspond to lower,

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to a predicted lower average future real GDP growth

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and a predicted higher probability

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of a financial crisis down the road.

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Now that literature has primarily focused on trying

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to understand, the distinction

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between different types of borrowers. So for

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Example, the distinction between, credit expansions

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to the household sector versus credit expansions

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to the firm sector.

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Within the firm sector.

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People, have thought about, credit expansions,

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going to the tradable sector versus the non tradable sector.

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And so one of the things

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that we do differently in our study is instead of, instead

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of focusing on different borrowers, we're going

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to be focusing on different lenders in the broader context.

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Um, that allows us to again, actually think about how

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different compositions

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of financial sectors across different countries translate

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into different credit cycles in those countries.

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Um, and, in particular, even though, there has,

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there is a small literature trying to think about how,

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credit cycles flow across different countries,

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we can actually think about the contribution

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of the external financial sector to,

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to credit cycles in a particular economy,

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that is separate from the contribution from the domestic

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financial sector because we're interested in understanding

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credit cycles across, a range of advanced economies.

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And because we're interested in understanding this

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composition of, lenders

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and how that translates into credit cycles, that required us

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to put together a few data sets from the perspective

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of understanding, where the credit is being financed.

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We are using, a flow of funds data from,

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from nine advanced economies.

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So flow of funds data is going to be measuring,

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in our case the balance sheets of,

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financial institutions at an aggregate level.

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So, in particular, we're going

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to think separately about banking institutions,

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insurance companies,

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and pension funds, mutual funds, other types

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of financial institutions, the household sector

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and the non-financial firm sector itself.

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One of the challenges in the exercise that we're doing is

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that unlike the standard version of flow of funds

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that just records, the composition of the asset side

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of the, of the balance sheet

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and the composition of the liability side

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of the balance sheet of each sector in the economy

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at a very aggregate level, we actually need to know,

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for example, when a bank, when a banking sector records

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loans on the asset side of their balance sheet,

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whether those loans are going to the non-financial sector,

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whether they're going to households,

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other financial institutions, et cetera.

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And so what that means is that for our purposes,

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we actually collected, not the just the standard flow

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of funds accounts, for the different countries.

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We actually collected, what are called who to

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who accounts, and the,

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and the difference in the who to who accounts is

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that you actually know what is the receiving sector

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of the credit provided.

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We're interested in trying to understand how,

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both the borrowers decide which type of credit they're going

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to be using and how the lenders decide,

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through which instrument

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and to whom they're going to be lending.

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It's important for us

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to capture credit pricing well, and what that meant.

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What that means is that, for, to the extent

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that we're able to observe them,

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we actually collected data on,

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credit pricing at the individual instrument level.

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And so that actually allows us to measure,

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much better the prices of credit in the,

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in the economy than just by relying on standard,

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credit pricing.

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In this piece, there are a couple of things that we need

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to keep in mind when we, think about,

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how credit actually arises in the economy.

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So from the perspective of the financial sub-sectors,

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we need to remember that different types

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of financial institutions fundamentally have very

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different business models.

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And so what that means is that different types

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of financial institutions have very different reasons

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for why they're going to be interested in providing credit

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to the real economy.

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And because they have a very different fundamental reasons

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for providing credit to the real economy,

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that translates into different financial institutions

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being interested in holding different types of instruments.

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And so what I mean by different types of instruments are,

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it goes anything from the distinction between,

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bonds and loans.

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So, for example, we think of the banking sector

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and the economy as traditionally being, the originator

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of loans and the holder of loans

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where something like an insurance company is going

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to be much more interested in holding,

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corporate bonds than in holding loans

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and in particular, holding corporate bonds issued

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by higher rated issuers.

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But we can also think about the distinction between,

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not just along the dimension of loans versus bonds,

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but also, along the dimension

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of the maturity of the bonds.

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So again, insurance companies are probably going

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to be interested in longer maturity bonds than,

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let's say a hedge fund is going to be interested in.

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Um, and at the same time, these

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different fundamental preferences for the types

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of instruments that,

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these financial institutions are interested in holding

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are coupled with,

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Potentially fundamentally different funding structures.

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And so on the one hand,

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we have financial institutions being interested in

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potentially holding different types of credit instruments

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at the same time, different types

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of financial institutions have different cyclical properties

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of their balance sheet.

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And so what that means that from the perspective

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of the corporate borrowers, they face the choice

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between, funding themselves through loans

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or bonds, which,

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because bonds tend to be fixed coupon longer maturity,

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whereas loans tend to be shorter maturity floating rate,

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those distinctions of course translate by themselves

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into,

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into different properties from the

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perspective of the borrower.

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So for example, we saw, in,

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in the spring and summer of 2020, a lot of firms

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issuing bond, very long maturity bonds

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that helped insulate them to some extent from

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the subsequent interest rate rises.

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Um, and at the same time that firms, again,

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themselves have very different reasons for why,

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they want to issue a bond versus a loan.

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They're faced with these lenders who

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not only have different preferences for different types

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of credit instruments,

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but also have, different cyclical properties of,

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their balance sheet.

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And, essentially you are overlaying the,

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let's say the different, cyclicality properties

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of the instruments themselves

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with the different cyclicality properties

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of the holders of those instruments.

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One of the key aspects of our approach is

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that we can actually think about how things like,

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the borrower preferences as well as the composition

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of the financial sector, the state of the economy, the,

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preferences of the financial sector translate into

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variation, in both the total amount of credit,

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being extended in the economy as well as the share

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of intermediated credit.

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So for example, when we look at how, the share

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of intermediated credit, which is the share of loans

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relative to the total amount of loans

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and bonds, outstanding changes year to year on average

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for the nine advanced economies in our sample, we find

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that about a third of that variation is accounted for

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by the level of interest rates in the economy.

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So for us, we're just measuring that with a,

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10 year sovereign yield.

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Another third of it is going to be accounted for

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by variation in, the size of the banking sector as well

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as bank like, non-bank financial intermediaries.

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And then the final third is going to be accounted for by,

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the preferences of the borrowers.

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So if the non-financial sector itself is more interested in

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borrowing through loans, of course that's going to lead

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to a greater fraction of their credit being represented,

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by loans.

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And one of the overarching themes, in what we find is

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that not all non-bank financial institutions are the same.

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Um, so going back to what we started with in terms of,

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bank, in terms of credit

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provided by banks versus credit

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provided by non-banks, if we actually dig deeper

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into the composition of that non-bank, sector, we find

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that there are some, types of financial institutions

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that are going to act more as insulators in the economy.

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So those would be the insurance companies, mutual funds,

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pension funds, whereas other types

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of financial institutions are going to be, are going

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to act much more similarly to,

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the traditional banking sector.

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So in, national, in flow of funds account,

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parlance,

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those institutions are called it other financial

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institutions, but essentially those tend to be institutions

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that, for example, originate mortgages outside

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of the banking sector

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and provide other type of loan financing, both to the,

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non-financial sector as well as

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to the rest of the financials.

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One of the conclusions from, the study in particular is

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that, a better understanding of, how the supply of

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credit to non-financial firms, as well

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as households is determined by the composition

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of the financial sector

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and the economy is, a key determinant

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of the future real outcomes, following,

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that credit expansion.

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And again, one of the things that we find in our research is

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that, partially

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because different instruments are held

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by different financial institutions,

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but the instrument through which the non-financial sectors

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borrowing is actually going to be,

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a very important in terms of the future real outcomes.

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Now to try to really understand,

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why the particular instrument matters

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or why the particular lender matters, one

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of the important directions for future research is to try

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to use, micro data to actually study these questions.

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So what I mean by micro data in this context is instead

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of using, flow of funds, data at the country level,

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actually looking at individual firms balance sheets,

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looking at the, at the composition of,

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credit at the individual firms.

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And that's something that, we are, working on

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as part of our research agenda.

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And, again, coupled with,

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what we find in this paper, we think it's important

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to understand that, firms

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actively manage the composition of their debt, both in,

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again, in terms of, loans versus bonds,

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but also in terms of the maturity, composition,

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currency composition, et cetera.

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And, because the willingness

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of financial institutions to hold different types of debt

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to hold different maturities is also going to fluctuate

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with the financial cycle.

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We're trying to actually understand how

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the global financial cycle interacts with the ability

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and willingness of firms to actually manage,

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their debt composition in the way that they want,

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and how that translates in how

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and how when firms are cons constrained in their ability

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to manage their debt effectively, how

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that translates into potentially

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adverse outcomes at the firm level that then,

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rolls up into adverse outcomes at the economy level.

Understanding Credit Cycles Post-Crisis

00:00:00 - This work was, the renewed interest in understanding credit cycles, that we saw after the financial crisis. So, of course, even though, there was a, large literature in the seventies and eighties trying to think about the consequences of credit crisis and where credit crisis, can arise from with the financial crisis with, we saw a renewed interest in that work. What that, post-crisis work found was that,

00:00:36 - adverse real outcomes. What we're doing in our study is actually trying to think, more holistically about where credit to non-financial, arises from. And so in particular, we're interested in studying the interactions between borrowers and lenders in, the credit market for non-financial firms. and, one of the things that we find is

00:01:07 - who the lenders are that are providing credit in the economy. And so from a very big picture perspective, one of the things that we show upfront is that, credit cycles financed by, banking institutions are going to look very different from credit cycles financed by non-bank institutions. For example, the credit cycles finance by non-banking institutions are potentially going to have fewer of the negative real effects that,

Impact of Credit Expansions on Economic Stability

00:01:41 - In general. The literature, that has focused on trying to understand how, the effects that credit cycles have on future activity has found, two things. The first is that credit expansions, even though they help finance growth in the short run, they tend to lead to, negative real outcomes in the longer run. So at the, around the five year horizon, let's say,

00:02:12 - And at the same time, a rapid credit expansion tends to predict a higher probability of, banking crisis and financial crisis. So what that means is that when, credit is expanding rapidly in the economy, there is a higher likelihood of, that credit expansion than turning into a credit contraction, which then is going to correspond to lower,

00:02:44 - and a predicted higher probability of a financial crisis down the road. Now that literature has primarily focused on trying to understand, the distinction between different types of borrowers. So for Example, the distinction between, credit expansions to the household sector versus credit expansions to the firm sector. Within the firm sector. People, have thought about, credit expansions,

Exploring Lender Dynamics in Credit Cycles

00:03:17 - And so one of the things that we do differently in our study is instead of, instead of focusing on different borrowers, we're going to be focusing on different lenders in the broader context. that allows us to again, actually think about how different compositions of financial sectors across different countries translate into different credit cycles in those countries.

00:03:48 - there is a small literature trying to think about how, credit cycles flow across different countries, we can actually think about the contribution of the external financial sector to, to credit cycles in a particular economy, that is separate from the contribution from the domestic financial sector because we're interested in understanding

00:04:20 - And because we're interested in understanding this composition of, lenders and how that translates into credit cycles, that required us to put together a few data sets from the perspective of understanding, where the credit is being financed. We are using, a flow of funds data from, from nine advanced economies. So flow of funds data is going to be measuring,

Analyzing Financial Institutions and Credit Flow Dynamics

00:04:52 - financial institutions at an aggregate level. So, in particular, we're going to think separately about banking institutions, insurance companies, and pension funds, mutual funds, other types of financial institutions, the household sector and the non-financial firm sector itself. One of the challenges in the exercise that we're doing is that unlike the standard version of flow of funds

00:05:26 - of the, of the balance sheet and the composition of the liability side of the balance sheet of each sector in the economy at a very aggregate level, we actually need to know, for example, when a bank, when a banking sector records loans on the asset side of their balance sheet, whether those loans are going to the non-financial sector, whether they're going to households,

00:05:55 - And so what that means is that for our purposes, we actually collected, not the just the standard flow of funds accounts, for the different countries. We actually collected, what are called who to who accounts, and the, and the difference in the who to who accounts is that you actually know what is the receiving sector of the credit provided. We're interested in trying to understand how, both the borrowers decide which type of credit they're going

Understanding Credit Pricing Across Financial Instruments

00:06:28 - through which instrument and to whom they're going to be lending. It's important for us to capture credit pricing well, and what that meant. What that means is that, for, to the extent that we're able to observe them, we actually collected data on, credit pricing at the individual instrument level. And so that actually allows us to measure,

00:06:58 - in the economy than just by relying on standard, credit pricing. In this piece, there are a couple of things that we need to keep in mind when we, think about, how credit actually arises in the economy. So from the perspective of the financial sub-sectors, we need to remember that different types of financial institutions fundamentally have very different business models. And so what that means is that different types of financial institutions have very different reasons

00:07:32 - to the real economy. And because they have a very different fundamental reasons for providing credit to the real economy, that translates into different financial institutions being interested in holding different types of instruments. And so what I mean by different types of instruments are, it goes anything from the distinction between, bonds and loans.

Distinct Preferences in Financial Instruments Among Institutions

00:08:02 - and the economy as traditionally being, the originator of loans and the holder of loans where something like an insurance company is going to be much more interested in holding, corporate bonds than in holding loans and in particular, holding corporate bonds issued by higher rated issuers. But we can also think about the distinction between, not just along the dimension of loans versus bonds, but also, along the dimension

00:08:32 - So again, insurance companies are probably going to be interested in longer maturity bonds than, let's say a hedge fund is going to be interested in. and at the same time, these different fundamental preferences for the types of instruments that, these financial institutions are interested in holding are coupled with, Potentially fundamentally different funding structures. And so on the one hand, we have financial institutions being interested in

00:09:06 - at the same time, different types of financial institutions have different cyclical properties of their balance sheet. And so what that means that from the perspective of the corporate borrowers, they face the choice between, funding themselves through loans or bonds, which, because bonds tend to be fixed coupon longer maturity,

Impact of Credit Instruments on Borrower Strategies

00:09:38 - those distinctions of course translate by themselves into, into different properties from the perspective of the borrower. So for example, we saw, in, in the spring and summer of 2020, a lot of firms issuing bond, very long maturity bonds that helped insulate them to some extent from

00:10:09 - and at the same time that firms, again, themselves have very different reasons for why, they want to issue a bond versus a loan. They're faced with these lenders who not only have different preferences for different types of credit instruments, but also have, different cyclical properties of, their balance sheet. And, essentially you are overlaying the,

00:10:41 - of the instruments themselves with the different cyclicality properties of the holders of those instruments. One of the key aspects of our approach is that we can actually think about how things like, the borrower preferences as well as the composition of the financial sector, the state of the economy, the, preferences of the financial sector translate into variation, in both the total amount of credit,

Factors Influencing Intermediated Credit Variations

00:11:14 - of intermediated credit. So for example, when we look at how, the share of intermediated credit, which is the share of loans relative to the total amount of loans and bonds, outstanding changes year to year on average for the nine advanced economies in our sample, we find that about a third of that variation is accounted for by the level of interest rates in the economy. So for us, we're just measuring that with a,

00:11:46 - Another third of it is going to be accounted for by variation in, the size of the banking sector as well as bank like, non-bank financial intermediaries. And then the final third is going to be accounted for by, the preferences of the borrowers. So if the non-financial sector itself is more interested in borrowing through loans, of course that's going to lead to a greater fraction of their credit being represented,

00:12:21 - And one of the overarching themes, in what we find is that not all non-bank financial institutions are the same. so going back to what we started with in terms of, bank, in terms of credit provided by banks versus credit provided by non-banks, if we actually dig deeper into the composition of that non-bank, sector, we find that there are some, types of financial institutions

Understanding Credit Supply Dynamics

00:12:55 - So those would be the insurance companies, mutual funds, pension funds, whereas other types of financial institutions are going to be, are going to act much more similarly to, the traditional banking sector. So in, national, in flow of funds account, parlance, those institutions are called it other financial institutions, but essentially those tend to be institutions

00:13:26 - of the banking sector and provide other type of loan financing, both to the, non-financial sector as well as to the rest of the financials. One of the conclusions from, the study in particular is that, a better understanding of, how the supply of credit to non-financial firms, as well as households is determined by the composition

00:13:56 - and the economy is, a key determinant of the future real outcomes, following, that credit expansion. And again, one of the things that we find in our research is that, partially because different instruments are held by different financial institutions, but the instrument through which the non-financial sectors borrowing is actually going to be, a very important in terms of the future real outcomes.

Exploring Micro Data on Debt Management in Firms

00:14:33 - why the particular instrument matters or why the particular lender matters, one of the important directions for future research is to try to use, micro data to actually study these questions. So what I mean by micro data in this context is instead of using, flow of funds, data at the country level, actually looking at individual firms balance sheets,

00:15:03 - credit at the individual firms. And that's something that, we are, working on as part of our research agenda. And, again, coupled with, what we find in this paper, we think it's important to understand that, firms actively manage the composition of their debt, both in, again, in terms of, loans versus bonds,

00:15:33 - currency composition, et cetera. And, because the willingness of financial institutions to hold different types of debt to hold different maturities is also going to fluctuate with the financial cycle. We're trying to actually understand how the global financial cycle interacts with the ability and willingness of firms to actually manage,

Debt Management Constraints and Economic Outcomes

00:16:20 - and how that translates in how and how when firms are cons constrained in their ability to manage their debt effectively, how that translates into potentially adverse outcomes at the firm level that then, rolls up into adverse outcomes at the economy level.

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