Should we blame toxic loans for a financial crisis?

There is no need to toxic loans for a financial crisis. It is the nature of risk transformation of the financial system that causes systemic risk during economic downturns.

In a financial distress, people get frustrated to the banking sector. As the financial sector is distressed in many countries due to the COVID-19 shock, zombie firms are once more blamed for deteriorating financial conditions.

Even in the absence of toxic loans, risks inherint to the financial sector can easily convert into a financial crisis.

Risks are born from the functions of financial agencies. Banks transform savings into investments by means of 3 functions.

Why do banks exist?

In an economy, usually, savers and investors are not the same people. Without financial institutions, a saver would need to gain expertise and spend time to pick and monitor the profitable investments. In such conditions, obviously, risk avoiders would just keep their money in their vaults and would not invest in anywhere. On the other side, entrepreneurs would not access the capital to establish businesses. In such an economy, investment and employment opportunities would be limited.

Banks succeed to collect the idle resources in the economy promising the lenders their capitals plus a preset amount of interest. Accordingly, savers do not need to have concerns depositing their money in a bank. In consequence, centralization of the savings in the banking sector creates a huge source for the investments. This centralized financial giant hires talented people and creates most advanced techniques to lend to the best opportunities and monitor the progression of the investments. Consequently, banking sector is expected to contribute to the growth of the economy by transforming the savings into investments in the most effective way (Lulford, 2014).

Functions of Banks

Banks succeed to centralize the idle financial resources by 3 functions deriving from 3 risks.

The first function of a bank is possibly the most popular one, liquidity transformation (Armour, 1999). This function is fulfilled largely by the depository banks via hundreds of thousands of ATMs and branches. In fact, the miracle of the banking sector is originated from this function. People deposit a larger amount of their money in the banks since they can withdraw it 7 days, 24 hours, from an ATM regardless of its location. Thus, the idle money in the pockets can be minimized; and money can be collected in the pool of the banking sector.

Second function of the banking sector enables the economy to grow. Banks promise depositors to pay their money any time they’d like. On the contrary, investments require years to break even. As maturity transformers, banks provide long-term loans with their short-term liabilities. Otherwise, it would be impossible to fund a mortgage with monthly payments of 30 years (Armour, 1999).

Third function of the banks saved people from pawnshops. In the absence of the banks, risky borrowers would pay a fortune as interest. Banks transform less risky liabilities into more risky credits. Thus, low-income segment of the society can reach financial resources. Moreover, failed entrepreneurs can get a second chance (Armour, 1999). Given that most innovations are a result of infinite unsuccessful trials, as a funder of those trials, role of the banks in innovation can be better understood.

Liquidity Risk and Credit Risk

Attached to their functions, banks undertake 2 risks, which can be derived from their functions.

First risk of the banking system results from its liquidity and maturity functions, which depend on the assumption that all depositors would not ask for their money at the same time. This is true when people trust banks. However, in case of a panic, a snowball can quickly become a snow slip that not only devastates the financial sector but also the real sector. When banks go into default, they call commercial credits back leading to business failures. In the economies where the banking sector constitutes a considerable part of the economy, failure of banks lead to large-scale real sector devastation that raises the unemployment rate.

Second major banking risk is the credit risk. If borrowers do not fulfill their liabilities, banks still have to pay the deposits withdrawn. Hence non-performing loan (NPL) ratio is a vital performance indicator of the banking sector. The rise of the NPL ratio threatens the sustainable profitability of the banking sector.

Credit risk is very connected to the liquidity risk. In case of a liquidity shortage, banks cannot renew credits. Since a firm cannot pay back the capital of a revolving type of credit at once, default rates of business credits rise up in times of liquidity shortages. Hence, financial risks are easily transferable to the real sector (Teodora, 2014).

Conclusion

Even in the absence of toxic loans, risks inherint to the financial sector can easily convert into a financial crisis. On the other side, in the absence of banks, an economy would not realize its potential since savings could not be allocated into the most affective projects. Banks constitute the system that transforms savings into savings. To achieve this objective, they further transform liquidity, maturity and risk and undertake the risks derived out of those functions.

References

Armour, John, Dan Awrey, Paul Davies, Luca En riques, Jeffrey Gordon, Colin Mayer and Jennifer Payne, 1999, Principles of Financial Regulation (Oxford: Oxford Universit. Press), pp. 275-289.

Lulford, Scott L., 2014, “How important are banks for development? National banks in the United States 1870–1900”, access September 20, 2018. http://fmwww.bc.edu/ec-p/wp753.pdf

Teodora, Paligorova, Teodora and João A. C. Santos, 2014, “Rollover Risk and the Maturity Transformation Function of Banks”, access September 20, 2018. https://www.bankofcanada.ca/wp-content/uploads/2014/03/wp2014-8.pdf