Are bank lines of credit the new source of financial fragility?

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Through Teacher. Viral V. Acharya, CV Starr Professor of Economics, Department of Finance, New York University Stern School of Business (NYU-Stern), and Teacher. Dr. Sascha Steffen, professor of finance, Frankfurt School of Finance & Management

This article originally appeared in the Fall / November 2021 edition of International Banker

After the global financial crisis (CFM) of 2007-09, it was widely believed that the main source of stress for banks was short-term wholesale funding. As banks struggled to secure short-term funding raised in shadow banking markets, they passed the stresses on to the real economy. Post-crisis banking regulation has therefore focused on ensuring that banks have access to sufficient liquidity to meet wholesale funding needs.

Banking regulations, however, continue to suffer from the mole problem. Wholesale funding to total assets has halved since GFC. The emergence of a new source of banking stress has gone almost unnoticed: the drawdowns on lines of credit, which are commitments by banks to grant new loans to businesses on demand and under predetermined conditions. Banks receive commissions on time while providing these liabilities, but must honor them when they are drawn down and, most importantly, hold significantly more capital afterwards.1

Massive accumulation of banking risk from the GFC

Figure 1 shows the increase in line of credit commitments to publicly traded US companies from GFC. These fell from 0.7% of gross domestic product (GDP) in 2009 to 5.7% of GDP in 2019. By the end of 2019, banks had pledged to provide around $ 1.2 trillion. loans only to listed American companies, to the exclusion of their commitments. carried out in parallel with high-risk LBO transactions, these companies being mostly private. Funding of the bond market, meanwhile, has increased to over 20% of GDP, while bank term loans have declined.

In other words, over the past decade, banks have accumulated massive amounts of off-balance sheet risk through loan commitments that can materialize when overall risk in the economy increases, as financing of capital markets disappear and so do treasurers and chief financial officers (CFOs) when companies decide they should use their bank lines of credit.

The risks of shadow banks returned to the banking sector in March 2020

This global drawdown risk materialized in March 2020 in the midst of the outbreak of the COVID-19 pandemic. Governments have imposed strict lockdowns, resulting in immediate and expected cash flow from businesses declining, in some cases by as much as 100%, while their operational and financial levers remained stable. With increased uncertainty, bond markets froze for virtually all companies and renewal costs have skyrocketed, even for the highest rated. As a result, companies with pre-established lines of credit with banks reduced their unused loan commitments in the first three weeks of March 2020, until monetary and fiscal authorities intervened. In other words, the rollover risks that had accumulated for companies in the bond market (and more broadly the “shadow banking” sector) returned to banks’ balance sheets via drawings on credit line commitments. credit.

The banks had already known this kind of “bank run” during the GFC, in particular after the bankruptcy of Lehman Brothers. The intensity of drawdowns on lines of credit during COVID-19, however, was much higher than during the GFC or other past recessions. To put it in perspective, the size of large corporate bank withdrawals was over $ 300 billion in March 2020, exceeding the annual retired in 2008-09. As a result, bank stock prices collapsed in the first few weeks of the pandemic, far more so than those of non-financial companies.

Federal Reserve programs have supported the banking sector

The US Federal Reserve reacted eagerly to the events of early March 2020 and introduced a series of measures to inject liquidity into the market. On March 23, he introduced a corporate bond buying program, effectively supporting high-grade bonds. Bond markets immediately reopened for investment grade rated companies, and possibly also for riskier, non investment grade rated companies. This ended the scramble for bank credit lines and was an important, albeit indirect, mechanism for preserving bank stability.

In the second half of 2020, companies began to repay credit lines, but they did not significantly reduce their cash flow. In fact, companies have issued new bonds to pay off lines of credit. This had two implications: First, banks re-committed to lending when companies wanted to tap into their lines of credit, i.e. banks’ off-balance sheet exposures to aggregate risks and parallel bank freezes. have been reinstated. Second, companies had significantly more financial leverage. In other words, if additional foreclosure measures were to be imposed in the wake of, say, a second or third wave of the pandemic, the withdrawal risks for banks could have reappeared and likely be even more pronounced. As a result, bank stock prices did not recover significantly before the advent of vaccines in late 2020 and lagged behind recoveries in other sectors.

Banks with large drawdowns have stopped lending

The drawdowns on lines of credit had immediate implications for bank lending. During GFC, markets and regulators were concerned about the wholesale funding risks of banks, not only from a bank capital perspective but also bank liquidity. Liquidity risk, however, was not a major concern for banks during COVID-19. The funds from the drawn lines of credit were re-deposited, often in the same banks. In addition, the Federal Reserve quickly injected sufficient liquidity into the banking sector.

However, as liabilities turned into loans on banks’ balance sheets, they had to be funded with higher levels of capital. The riskier the loan, the higher the required capital. This had a significant impact on the ability of banks to issue new loans, especially as banks feared higher loan loss provisions during the first phase of the pandemic. Banks that have suffered large drawdowns have been forced to cut back on lending to businesses. We can thus observe a decrease in investments and R&D (research and development) expenditure by companies borrowing from these banks. The drawdowns on lines of credit therefore appear to have had medium-term implications for the economic growth of US companies.

To sum up, the COVID experience has shown us that the bond market refinancing risks that accumulate in the shadow banking sector can be reinjected into the banking sector through line of credit commitments provided by banks to businesses, with important implications for bank lending and the economy. Bank lines of credit are a growing source of financial fragility, with causes and consequences that merit careful regulatory scrutiny.

Reference:

1 A detailed analysis of the importance of line of credit commitments to banks can be found in the NYU Stern School of Business Discussion Paper “Why are bank stocks crashing during COVID-19?By Viral V. Acharya, Robert Engle and Sascha Steffen, August 31, 2021.

ABOUT THE AUTHORS

Teacher. Viral V. Acharya is CV Starr Professor of Economics in the Finance Department of the Stern School of Business at New York University (NYU-Stern) and Academic Advisor to the Federal Reserve Banks of New York and Philadelphia. He was Deputy Governor at the Reserve Bank of India (RBI) from January 23, 2017 to July 23, 2019, in charge of monetary policy, financial markets, financial stability and research.

Teacher. Dr. Sascha Steffen is professor of finance at the Frankfurt School of Finance & Management. His research focuses on banking, corporate finance and financial intermediation. His recent work analyzes the causes and consequences of the European banking crisis and its implications for business financing and investment opportunities. Before joining academia, he worked at Deutsche Bank in Frankfurt and New York.


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