decrease. This affects the bank's ability to mobilize capital from other banks, leading to a decrease in lending activities. Figure 2.1 shows the impact of increasing interest rates on commercial banks as well as the ability of businesses and customers of banks to repay debts.
The reason is the problem of asymmetric information between borrowers and lenders. Due to lack of information, banks often require customers to mortgage assets. If asset prices fall, it will affect the balance sheet and net worth of the enterprise. This reduces the ability to repay debts and negatively affects investment. This channel operates through the surplus of external funds, reflecting the difference in the cost of external and internal funds (Bernanke et al., 1994; Kiyotaki and Moore, 1995). Bernanke et al. (1994) argued that the relationship between net worth and surplus of external funds is inverse. As the economy grows, net worth improves, the surplus of external funds becomes lower, as banks believe that lending to subjects with higher net worth is less risky. The reverse shock is that the lower the borrower's current cash flow, the lower the net worth and the higher the surplus of external funds. The increase in the cost of borrowing will discourage them from investing more and as a result affect the demand for credit, which will affect and amplify the effect of the initial shock.
Central Bank raises interest rates
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Reserve value decreases (due to falling stock and bond prices)
Difficult to mobilize from other banks
The riskier the company, the commercial bank will not lend or only lend at high interest rates.
Company value decreases due to stock price
coupon
The company's finances deteriorated due to (i) high interest expenses, (i) falling demand
Loan reduction
Figure 2.1. Illustration of financial accelerator theory on the impact of macroeconomic factors on bad debt
Source: Bernanke et al. (1994)
- Bank lending theory
Based on the problem of asymmetric information and the role of financial intermediaries in minimizing the problem of asymmetric information, Bernanke and Gertler (1995) proposed that the bank lending channel includes two transmission channels: the borrower's balance sheet and the credit volume through the credit granting capacity of the banking system.
According to the theory of bank lending channel, the direct impact of monetary policy on interest rates is diffused through changes in the external capital surplus. The external capital surplus is the difference between externally mobilized capital (from issuing bonds, stocks, bank loans) and internally mobilized capital (from retained earnings). The extent of this difference reflects the imperfection of the credit market (the principal and agent problem).
costs; appraisal, monitoring, and collection costs; asymmetric information problems that cause adverse selection and moral hazard), creating a gap between the lender's expected return and the borrower's costs. Bernanke and Gertler propose two transmission channels through the borrower's balance sheet and the volume of credit through the banking system's ability to extend credit.
+ Balance sheet channel theory
In addition to the impact of the credit channel on firms, theories also refer to the borrower balance sheet channel. When bank credit declines due to a contractionary monetary policy, it reduces the purchasing power of consumers who do not have access to other sources of credit. Similarly, rising interest rates erode borrower balance sheets because consumers' cash flows are negatively affected. Due to asymmetric information, consumer durables and housing are illiquid. If faced with an income shock, borrowers must sell consumer durables to raise money and expect to accept a large loss when selling them. In contrast, if they hold financial assets such as bank deposits, stocks, and bonds, consumers can easily sell them and collect cash. Therefore, if consumers fall into financial difficulties, they will hold fewer illiquid consumer goods and hold more liquid financial assets. A borrower's balance sheet has a significant impact on estimates of their likelihood of financial distress.
The basis of this transmission channel is that the surplus of external financing is inversely proportional to the financial position of the borrower. The larger the net worth (total assets minus total liabilities) and the value of the borrower’s liquid assets, the smaller the external financing premium. Tight monetary policy has a direct impact on the financial position of the borrower through two effects. The first effect is through short-term and floating-rate loans; higher interest rates lead to higher interest costs, which reduce profits, cash flows, and net worth, especially for businesses and households.
The second direct impact is that when interest rates increase, the value of assets used as collateral will decrease. On the indirect side, when the central bank tightens monetary policy, enterprises producing intermediate goods will face difficulties due to decreased revenue (decreased demand from partners) while fixed costs remain the same, causing the profits of enterprises to decrease and the value of net assets to decrease. The combination of direct and indirect impacts is that the value of net assets and collateral decreases, causing the reward for external capital to increase due to increased potential risks for lenders; as a result, borrowers (including enterprises and households) will limit their demand for investment and consumption of durable goods.
+ Credit channel theory
Commercial banks are the entities that provide the majority of credits to other entities in the economy, so when the ability to provide credit is reduced, it will cause businesses that depend on credit, especially small and medium enterprises (Gerlter and Gilchrist, 1993) in economies where the stock market is not yet developed, to have difficulty maintaining operations. Bernanke and Blinder (1988) argued that when the central bank tightens monetary policy by selling securities on the open market, the reserves and deposits of the commercial banking system will decrease. Because the issuance of debt instruments and stocks to compensate for the decrease in deposits is not easy, the ability of commercial banks to provide loans will decrease; investment and consumption of entities in the economy will also decrease. Kayshap and Stein (1994) show that banks with low liquidity ratios are more affected by changes in monetary policy than banks with high liquidity ratios. This finding is particularly true for banks with small size and weak financial status. Thus, the two credit transmission channels are closely related in the process of transmitting monetary policy to the economy.
The process of financial liberalization and the application of new financial instruments have reduced the role of the transmission channel through the ability to provide credit. While
Therefore, the combination of these two transmission channels is increasing due to the increasing linkage between commercial banks in the financial market, which originates from the complexity of financial transactions between commercial banks (borrowing on the interbank market, capital investment, securitization, derivative instruments, etc.). However, for developing countries with financial markets in the early stages of development, the role of the transmission channel through credit to the economy is still very important. In addition, the credit transmission channel has implications for policy makers that businesses, households and commercial banks with weak financial status are the subjects that are easily affected by negative impacts from changes in monetary policy and vice versa. The transmission channels of monetary policy do not operate independently but operate together in response to changes in the monetary policy management of the central bank.
Thus, through the bank lending channel, the impact of macroeconomic factors on bad debt is explained through credit market imperfections, causing adverse selection and moral hazard. This affects the bank's ability to provide credit as well as the borrower's costs and affects the borrower's ability to repay, possibly increasing bad debt if the borrower's costs increase and vice versa.
- Monetary policy transmission mechanism theory
Bad debt is not only affected by the separate credit channel as analyzed above but also by the combined transmission mechanism of monetary policy. At that time, the transmission mechanism of monetary policy changes macroeconomic factors (such as interest rates, inflation, exchange rates, unemployment, etc.) that will affect the debt repayment capacity of enterprises and households in the economy and thus affect bad debt. According to Miskin (2010), the transmission mechanism of monetary policy is the process from changes in interest rates (or money supply) of the monetary policy executive agency affecting the price level and output of the economy. The transmission mechanism of monetary policy is a process in which changes in monetary policy lead to a series of other changes.
in economic variables such as interest rates, asset prices, spending, consumption, exchange rates, cash flows, the credit capacity of the commercial banking system and finally towards the target price level, output and unemployment. Expansionary monetary policy leads to a decrease in real interest rates and the decrease in real interest rates reduces investment costs, causing an increase in investment spending, thereby leading to an increase in aggregate demand and output. The impact of monetary policy on macroeconomic variables through the traditional interest rate channel is approved by many economists, studies also show that in addition to interest rates, other lagged factors such as output, revenue and cash flows are the factors that have the strongest influence on spending and consumption (Blinder and Maccini, 1991; Chirinko, 1993; Boldin, 1994).
According to Bernanke and Gertler (1995), monetary policy has been ineffective in reducing medium and long-term interest rates, especially real interest rates, which play an important role in the decision to invest in long-term assets. The transmission channels of monetary policy do not operate independently but operate together in response to changes in the monetary policy management of the central bank. Therefore, assessing the impact of monetary policy on credit growth plays an important role in evaluating the management of monetary policy. Thus, the transmission channels of monetary policy such as the balance sheet channel, the credit capacity channel, the cash flow channel, and the price level fluctuation channel affect bad debt through macroeconomic factors such as interest rates, cash flows, asset prices, and exchange rates, thereby affecting adverse selection and moral hazard, affecting the investment or consumption activities of borrowers, and affecting the ability to repay debts and the quality of loans.
In summary, the above theories show that macroeconomic policies affect the bank lending channel in the economy, thereby affecting the quality of loans or bad debts of banks. This relationship will be presented more clearly in the following contents.
2.1.3.2. Specific factors of banks
- Credit growth
The relationship between credit growth and bad debt is explained by Keeton (1999) through the shift of factors in the relationship between credit growth and bad debt. Thereby, the relationship between these two factors is reflected in both positive and negative directions. The shift of the supply curve in the loanable funds market in Figure 2.2 explains this relationship as follows: the expected rate of return curve reflects the expected rate of return corresponding to the credit standards set by banks. The shift of the supply curve implies that commercial banks are willing to lend more by reducing credit standards. This makes commercial banks willing to expect lower rates of return and make it easier to lend to high-risk borrowers.
r e 1
Figure 2.2. Shifting the supply curve
re, expected rate of return
r e (z)
S 1
S 2
r e 1
r 2
e
r e 2
z 1
z 2
D
L 1
L 2
L, total capital
loan
z, creditworthiness
Source: Keeton (1999)
Thus, when commercial banks decide to increase credit growth by loosening lending conditions, the credit growth will reduce future credit quality. This process occurs as follows: a decrease in credit standards will lead to increased credit growth, which will reduce credit quality.
Two other reasons explaining how credit growth affects bad debt are the shift in demand curve and the shift in labor productivity. First, due to the need to change the capital structure of enterprises or investment projects, the credit demand curve will shift to the right. This change in capital structure will help improve cash flow, thereby, the ability of borrowers to repay debts will not be negatively affected, ensuring credit quality in the future. Second, the shift in demand curve is due to the shift in labor productivity. The increase in labor productivity shows good signs for borrowers. Thus, credit growth will have a positive relationship with bad debt.
Figure 2.3 suggests that when the demand for loans comes from the desire to change the capital structure to reach the optimal level, commercial banks will carefully consider loan requirements and tighten credit standards. Normally, commercial banks will not recognize this type of loan demand, so they initially keep credit standards at a certain threshold until they see many qualified borrowers coming to borrow, they begin to tighten and expect higher rates of return. This may not hinder borrowers and banks from reducing the risk of lending to borrowers with poor financial capacity. Therefore, credit quality will improve in the future. The process is as follows: increased credit growth will lead to increased credit standards and this will reduce bad debts.
Figure 2.3. Shifting the demand curve
re, expected rate of return
r e (z)
D 2
S
D 1
r e 1
r e 2
z 1
z 2
L 1
L 2
L, total loan capital
z, creditworthiness
Source: Keeton (1999)