Bank policies and actions usually have a direct impact on individuals’ credit decisions and, in turn, on economic growth, according to an article included in the latest Cyprus Economic Policy Review by the University of Cyprus Economic Research Center.
According to the findings of the study, quantifying the impact of a shock to lending criteria, which reflect banks’ willingness to take on risk, plays a critical role in assessing policy actions and their potential effects on the wider economy.
In the article authored by Nektarios A. Michael and Christos S. Savva, it is noted that safeguarding banking stability and loan sustainability promotes consumer spending and confidence, new business ventures, and the ability of companies to grow and improve.
However, they stress that this is not always possible, especially during crises when uncertainty prevails. For example, they explain that before the 2008 financial crisis, optimism dominated, with banks making risky investments and using homes with highly inflated values as collateral. This belief weakened banks’ perception of credit risk in the economy and led to a relaxation of lending standards.
As a result of lower risk perceptions, banks extended loans to borrowers with very high credit risk (sub-prime). These loans ultimately contributed significantly to the Great Recession, during which banks suffered major losses.
“Given the importance of supply-side factors in lending, and particularly perceptions of banking risk, greater emphasis should be placed on lending criteria, which capture risk as perceived by the banking sector,” the authors underline.
Key Findings
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Stricter lending criteria are negatively associated with the volume of loans to both non-financial corporations and consumer categories, with the maximum impact appearing about five quarters after the change.
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Business loans show a stronger response, consistent with existing literature.
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After lending criteria tighten, inflation reacts negatively, while GDP growth and interest rates show no significant effects.
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A positive shock in loan demand leads to an overall increase in lending.
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GDP growth has a positive impact lasting about five quarters on lending criteria, especially for businesses.
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An inflation shock causes stricter lending standards across all loan types, with effects lasting around eleven periods.
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Findings show a positive relationship between interest rates and lending criteria, with stricter standards following rate increases.
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A similar relationship exists between lending criteria and inflation, as rising inflation leads to tighter standards.
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“Since stricter credit standards reduce loan growth, their positive relationship with inflation suggests, perhaps paradoxically, that loan growth is higher during periods of low inflation,” the study notes.
“Our results have significant implications for economic policy, as the banking sector plays a crucial role in the economy and must use this function as a catalyst for growth. Examining banks’ actions can help us understand how the sector might respond to various shocks, such as changes in the macroeconomic environment or interest rates, and whether these changes would affect economic activity,” the authors emphasize.
They add that quantifying the impact of a shock to lending criteria, which reflect banks’ risk appetite, is also critical in evaluating policy measures and their potential effects on the overall economy.