Balance Sheet Strength and Bank Lending During the Global Financial Crisis

Abstract

Non-technical summaryIn the wake of the global financial crisis there have been renewed efforts to rethink the regulatory framework of the banking system. Such efforts rest on the assumption that banks with stronger capital and liquidity buffers are more resilient to financial shocks. Stronger banks should also be less likely to curtail credit during times of stress. In this paper, we use highly disaggregated data on international bank lending to examine the link between balance sheet strength and the supply of bank credit. We focus on the syndicated loan market, a large international corporate credit market in which loans are extended by groups of banks rather than individual banks. Our sample comprises more than 800 banks from 55 countries that lent to borrowers in 48 countries during 2006-10.Our main contribution is to take a novel look at what constitutes a strong bank balance sheet. In doing so, we draw heavily on recent proposals for bank regulation under the Basel III framework. In particular, we compute a complex measure of structural liquidity (the 'net stable funding ratio') that helps gauge the stability of a bank's funding sources relative to the market liquidity profile of its assets. But we also use traditional variables of bank health that capture bank's dependence on non-deposit (or market) funding. These indicators of balance sheet strength, measured before the crisis, reflect banks' vulnerability to the financial market shocks that took place during 2007-08.We find that banks that were more dependent on market funding reduced their supply of syndicated loans more than other banks. However, bank capital played a cushioning role: bettercapitalized banks that were exposed to the financial market shocks decreased their supply of loans less than other banks. The only measure of capital that delivers this result is similar to the simple leverage ratio proposed under the Basel III framework. By contrast, the traditional Tier 1 and total regulatory capital ratios from the Basel II framework are less useful for distinguishing which banks were better able to sustain lending. These results underscore the importance of bank capital for the recovery of credit after crises.We conclude that banks with stronger balance sheets were better able to perform their intermediation function during the recent crisis. We examine the role of bank balance sheet strength in the transmission of financial sector shocks to the real economy. Using data from the syndicated loan market, we exploit variation in banks' reliance on wholesale funding and their structural liquidity positions in 2007Q2 to estimate the impact of exposure to market freezes during 2007-08 on the supply of bank credit.We find that banks with strong balance sheets were better able to maintain lending during the crisis. In particular, banks that were ex ante more dependent on market funding and had lower structural liquidity reduced the supply of credit more than other banks. However, higher levels of better-quality capital mitigated this effect. Our result...

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