Financial system is destined to crumble
In the absence of macroprudential tools, self-correction means self-destruction for the financial system.
Financial agencies are inclined to lend to borrowers paying the highest rate of interest.
Financial institutions are attracted to high short-term profits at the expense of high NPL ratios in the long-term.
In normal times, defaulted credit losses are compensated by default risk premiums. The entire financial system falls into danger when a greater portion of risky borrowers defaults in bust times.
Profitable insolvent borrowers
Financial agencies are inclined to lend to borrowers paying the highest rate of interest. In boom times of an economy, risky borrowers are more profitable due to the high default premiums they pay. However, solvency of the whole financial sector is impaired when risky loans collectively default in bust times.
Financial institutions set a risk premium for each borrower based on the odds of default. Hence, a financial institution lends to risky borrowers willing to pay higher default risk premiums. Even insolvent firms can easily access financial sources by paying a higher risk premium. Those firms pay high interest costs through additional borrowing. Since unrealized default risk premiums count as profit, risky borrowers are the most preferred ones in the short-term.
Unrealized default risk premiums boost profits in boom times of an economy. Before the credit card crisis of South Korea, fees and interest rates on credit cards exceeded 20% while unsecured personal loan rates were 6-7% (Kang and Ma 2003). In 2001, the rate of return in the credit card industry was six times larger than the rate of return in the banking industry (Yun 2004).
Self-correction means self-destruction
Financial institutions are attracted to high short-term profits at the expense of high NPL ratios in the long-term. In normal times, defaulted credit losses are compensated by default risk premiums. However, the entire financial system falls into danger when a greater portion of risky borrowers defaults in bust times. Since default risks premiums of risky borrowers have already been distributed as profit, equities of financial agencies fail to cover losses. In the absence of macroprudential tools, self-destruction is the destiny of the financial system in every dramatic economic downturn.
To prevent the financial sector from extensive leveraging, macroprudential tools such as debt service to income (DSTI), debt to income (DTI) and loan to value (LTV) rules are employed. After 2008, economies generally took these measures against consumer borrowing. Meanwhile, unprofitable firms could rollover debt. Surging commercial credit risk once again raises anxiety in times of COVID-19. During the crises, zombie firms cannot be allowed to die altogether due to the contagion effect of defaults. Through liquidity measures of central banks, they need to be kept alive until good times. When economy recovers, their liquidation should gradually be materialized by macroprudential tools.
In some countries, lack of leverage tools allowed fragile borrowing. While interest rates remain low, zombie firms can stay alive via extending new debt. COVID-19 can help prepare the legal infrastructure for macroprudential tools that inhibit insolvent borrowing.
Literature
Kang, Tae Soo and Guonan Ma. 2007. “Recent Episodes of Credit Card Distress in Asia”, BIS Quarterly Review, June 2007. Accessed April 7, 2019. https://www.bis.org/repofficepubl/arpresearch_fs_200706.01.pdf
Yun, Seong-Hun. “Impact of Direct Regulations on the Korean Credit Market and Consumer Welfare”, Economic Papers, Vol. 7, no. 1, Bank of Korea. Accessed April 7, 2019. https://www.bok.or.kr/eng/bbs/E0000738/view.do?nttId=51740&menuNo=400220&pageIndex=8
