Essays on banking and finance

Abstract

This thesis looks into two specific topics regarding the relationship between bank lending and the economy. The first is about how non-performing loans (NPLs) are treated by individual banks, how their actions affect their viability, as well as its impact on the market for collateral. The objective is to provide insight into the decision-making process of a typical bank, and how decisions made from such a process impact on asset markets. The second topic relates to the transmission of monetary policy changes through variations in the volume of bank lending in Australia, with particular reference to the firms sector. Insight on this channel of transmission can contribute to the literature on how monetary policy is transmitted through the banking system and affects the wider economy. Chapter 2 explores the incentives that banks face when treating bad loans. Since write offs frequently involve losses, capital adequacy requirements present a binding constraint on banks' plans for liquidating bad loans. When bank safety is threatened, banks are forced to evergreen loans to bad customers and profitability is thus reduced. It is demonstrated that lowering regulatory capital requirements can ease this constraint and allow more liquidation of bad loans when liquidation is desirable. Chapter 3 investigates the effects on the asset market of bank actions in dealing with their NPLs, by extending the model in Chapter 2 to include interactions with the market for collateral. Results show that liquidation of bad loans may not be as detrimental to asset prices as commonly argued, because funds recouped from liquidation can be recycled into new loans which support the asset market. While capital regulation protects the bank health, it may sometimes limit the amount of liquidation and hence reduce the impact of the recycling channel'. This supports the idea that varying capital requirements countercyclically can dampen the economic cycle, notwithstanding the potential problems with making this a tool for economic management. Additionally, this chapter finds a distinction between two types of forbearance, that based on bank profit maximisation, and from concerns over a bank's financial health. Chapter 4 makes use of aggregate time series data in Australia to look into the strength of the bank lending channel of monetary policy. Investigation is done by examining whether monetary aggregates affect the spread between bank loan rates and bond rates. Results indicate that for small firms, the strength of the channel is dependent negatively on the size of the real deposit base. This is because deposits represent the supply of bank loans which if increased lowers bank lending rates. For large firms a different mechanism operates suggesting reduced influence of the channel, shown by larger loan volumes coinciding with a narrowing spread, implying that banks prefer to concentrate on lending to larger businesses. Rises in foreign funding coincide with a widening spread, but after a lag they also help to reduce upward pressure on loan rates, suggesting a weakening of the channel as foreign funding rises to relieve pressure on the market for bank loans.