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Banking Crises & Policy Making: A Schularick And Taylor Perspective

Features Characterizing Banking Crises & Policy Making
Schularick And Taylor Perspective



The rhetoric on financial crises in banking although a perpetual topic of contention among economists mostly revolves around macroeconomic disequilibrium and financial fragility. Schularick and Taylor (2012) offer an alternative assessment of the issue by focusing instead on a disequilibrium of monetary and credit systems. They argue that this microeconomic imbalance in the ratio of money to credit growth is one of the most significant features of a banking or credit crisis. This paper will, therefore, focus on elaborating the factors associated with such a financial crisis, moving from an overview of the significant macroeconomic factors involved to a discourse on how the different growth of credit versus monetary assets contributes to it. The discussion will elaborate on the significance of the increased leverage in the banking system compared to assets, the unstable credit growth and how these are critical predictors of a financial crisis. The paper will then demonstrate which of these features are most relevant to policymakers in the prediction and management of these types of financial crises. It will conclude with a summary of the significance of these features in financial crises and how this alternative assessment will be beneficial in policymaking relevant to the issue.

Macroeconomic Factors:

In its internal consensus and external influence, the subject of money and credit has witnessed many fluctuations under a brief history of macroeconomics. According to Schularick and Taylor (2012), there are two broad crises period pre-WW1 and post WW2. Their data covered 14 developed countries from 1870 to 2008. In their paper, they established the relationship with many historical and empirical researchers such as Bordo et al. (2001) and Reinhart and Rogoff (2014) to understand the causes for the financial crises to be the extent of macroeconomic factors. They underpinned different views but most importantly, money and credit aggregates, the role of monitory policy and how credit growth pushed policymakers to have significant importance because to them debt build up, international capital mobility and financial system itself is prone to generate economic instability (Kindleberger, 1978).


Decoupling of money and credit aggregates

The increasing decoupling of the money and credit aggregates in the banking system before a banking crisis as argued by (Schularick and Taylor, 2012) is one of the prime reasons for Global Financial Crises (GFC). Similar research by Paul (2017) suggests that crises are born out of prolonged credit-fueled boom periods. The policy of overreliance on credit growth along with an unfavourable balance sheet is a vital issue that foreshadows financial instability with an example of this being Japan’s Lost Decade (ECB, 2012). Considering these facts, credit growth is a robust predictor of crises because (Schularick and Taylor, 2012) examined that money and credit aggregates remain stable till the 1930s and once an expansion of banks’ balance sheets, a credit boom, or a buildup of leverage occurs, the process is coined as decoupling of money and credit aggregates (Demyanyk and Hemert, 2011).


Monetary policy, Policy Making & Credit Growth

The monetary policy responses to these financial events are generally delayed and often too late in addressing the underlying issues. Schularick And Taylor (2012) argued that after 1945, Financial Crises(FC) was fought with more aggressive monetary policy. Recently it has been critiqued that US monetary policy is susceptible to changes for many countries until and unless their borders are entirely closed to international capital flows (Avdjiev and Hale, 2018). Some other studies, however, find it opposite, or at least mixed results, (Cerutti et al., 2015), suggest that there is a positive relationship between cross-border bank flows related to short-term US real interest rates but have negatively affected by US term premium. The analysis infers that positive relationship occurs between the federal funds rate and cross-border bank lending, suggesting that tight monetary policy to post-crises speculation is much more predictable. This creates links to the “credit view” portrayed by (Schularick And Taylor, 2012) as they have also argued that monetary policy should follow “rule” in peruse of bank lending to emerging economies (Bruno and Shin, 2015).


Focus on Equilibrium

The focus on maintaining equilibrium as rightly pointed out is also ironically one of the features that personify a financial crisis. The increasing inter-reliance of banking systems around the world consequently also results in a domino effect in the event of a default by a major bank in one region that triggers a series of events across international systems that results in a significant economic downturn in the already lagging output growth of the world (Duncan and Nolan, 2017). This also points to the fragility of the international financial system as a whole in dealing with these issues.

International Financial Linkages & Fragility of Financial System

The financial linkages of many different money institutions in the early 19th century was the core issue of FC. Since Post WW2 bank lending exponentially rise as argued by (Jorda et al., 2014) since debt finance and the ratio of loans to GDP averages 33.2% and the corporate bond ratio was 19.2%. In contrast, Giesecke et al. (2014) and Krishnamurthy and Muir (2015) both have different arguments about the debt financing, they consider both for corporate and non-corporate borrowers, the difference between secured and non-secured loans because collateral mechanisms are mostly absent in bond default crises. Similarly, (Schularick And Taylor, 2012) argued that increasing reliance on debt securities and markets to fund balance sheet lending growth might be a severe problem. Hence, in the study of (Shin, 2012), it was seen that financial linkages domestically and internationally are prone to the ratio of credit to income which portrays to the fact that leveraged economies appear to be more at risk of steeper downturns and slower recoveries.

Monetary and Credit Systems

The origin of FC cannot be measured without the understanding of monetary and credit systems prevailing in the world economy since the start of the 19th century. Hence, researches have argued about many different viewpoints; some of them are discussed below.

Three Views of Money and Credit

Schularick and Taylor (2012) shed light to the three views of money and credit, to them “money view” have both broad and narrow supplies of money that influence short run, which trigger no effect of bank loans on the economy. Similarly, the second view, i.e. “irrelevance view” in which real economic decisions were made separate of financial structure, later in the 20th century, the “credit view” gained influence, and a decline in bank assets values escalated impair lending. All these views have a common propagator of shocks, i.e. “credit”. Vouching for the study of (Schularick And Taylor, 2012), Geanakoplos (2009) also portrayed that credit-driven instability throughout financial history is due to the cause of “credit borrowings” that led to the recent GFC 2008. Hence, money and credit aggregates could be considered the real cause of FC.


The Leveraging of Households

During the Era of Post WW2, housing price bubbles are closely associated with FC. In the study by (Raghuram Rajan, 2009) states that rising debt and rising income inequality were closely linked and housing in the US is closely related to debt to finance consumption. This infers to the fact that when economies experience three consecutive years of positive credit growth and averaging more than 5%, post researchers like Gorton and Ordoñez (2016, 2017) counts it as credit boom. Nevertheless, this ends after two precedent years of growth. Their study highlighted that during the boom, investment and productivity are relatively higher, which in turns come to the fact that credit growth is a potential predictor of financial crises as suggested by (Schularick And Taylor, 2012). In contrast, many researchers portray different growth trajectories for FC, (Valencia and Laeven, 2012) and (Reinhart and Rogoff, 2011), suggested that policy interventions during booms play a significant role in FC and bank runs lead to the closing of financial institutions.

Features Relevant to Policy Makers

(Assets & Balance Sheets, Regulation of Monetary Policy, Financial Regimes)

Policymaking during pre-WW1 and post-WW2, failed to address the rising issues of credit growth, as stated by (Schularick And Taylor, 2012) that policymakers and researchers ignore credit at their peril. Similarly, policymakers should address the assets and balance sheet of their financial institutions, because global recession that accompanied crises, many countries engaged in automatic fiscal policy which also increased the deficits (Bordo, 2017). In contrast, criticising the policy regimes during the financial fragility in US, Anginer, Demirguc-Kunt, and Zhu (2014) shed light that generous deposit insurance system increases bank risk and fragility, which eventually lead to recent GFC, for this, they suggested that bank supervision can alleviate the unintended consequences. Later, it was argued that politics of financial institutions make effective regulation impossible, policymakers will never tend for reforms, as its part of the conspiracy against the public.


Admitting to the fact that financial crises are part of the broad spectrum of issues, regulations and speculations, this paper has shed light in the core characteristics of banking crises as mentioned in (Schularick And Taylor, 2012).The brief discussion of money and credit highlight to the fact that numerous macroeconomic factors contribute to the financial crises such as monetary policy, regulation of credit borrowings and leveraging debts. Needless to say, that policymakers have failed to address the credit boom and adjust their regulations accordingly, that could be one of the predictors of financial crises. Since there is an extensive research gap and limitations of this paper, many issues that are core associated with banking crises have been left out such as global recession, inflation and unemployment, the rise in real estate spending in developing economies etc.

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