Financial Linkages and the Real Economy

The most recent Bank of Canada's senior loan officer survey showed that despite the historic level of monetary stimulus, bank lending in Canada is still remarkably tight. The implications for New Keynesian type forecasting models that rely on Taylor-type reaction functions is that the current disconnect between monetary policy and private sector borrowing conditions will be missed However, recent research by economists at the IMF offers a simple way to incorporate financial linkages loan officer survey data.

I am planning to incorporate these financial linkages into my larger model, but for now I thought it would be interesting to run a quick and dirty VAR. The figure below shows the impulse response of Canadian real GDP growth to a one standard deviation lending tightness shock.


This simple VAR analysis reveals that a one standard deviation shock to the BoC senior loan officer index (about 15 points) translates to a -0.35% decline in real GDP growth after four quarters. This would indicate that current lending conditions (an index reading of about 60) will have persistent negative effect on the economy and further highlights the importance of addressing the liquidity needs of the Canadian banking system.

Flaherty/Carney vs. Bankers

As discussed previously, Jim Flaherty and Marc Carney will be meeting with Canada's major banks to discuss tight credit conditions. Flaherty/Carney contend that the Banks have more than enough capital to satisfy risk management requirements and therefore should be lending more in order to stimulate the economy. The Banks in turn argue that they are already lending at a prudent level and that tight global credit conditions and elevated default risk are to blame for lower loan volume and the higher cost of capital.

What does the data say? Let's have a stroll through the weeds.

The table below shows the year-over-year change in loans to individuals from table C7 of the Bank of Canada's Banking and Financial Statistics:

		Loans to Individuals
		to purchase securities	autos	renovations	total
2007	I	5%	5%	12%	9%
	II	6%	4%	12%	9%
	III	8%	5%	15%	9%
	IV	1%	7%	17%	13%
2008	I	0%	8%	20%	15%
	II	1%	10%	24%	15%
	III	1%	26%	30%	16%

Thus far, personal loans have continued to increase, at least through the third quarter. I would guess that auto loans and borrowing for renovations will fall off in Q4 2008, but clearly banks are not withholding credit from households.

On the other hand, private business lending has fallen year-over-year by about 2%. Not too dramatic considering tight credit conditions throughout 2008. The table below shows lending activity to some important Canadian sectors:

		Loans to Canadian Businesses
		Financial	Mining	Energy	Forestry	Const.	Mfg	Total
2007	I	28%	128%	41%	-13%	18%	-3%	17%
	II	37%	172%	50%	-12%	15%	1%	13%
	III	33%	65%	38%	-10%	16%	-6%	14%
	IV	83%	9%	21%	-7%	20%	-2%	14%
2008	I	35%	12%	0%	0%	19%	0%	12%
	II	23%	-6%	-28%	-8%	18%	-5%	4%
	III	7%	-14%	-17%	-8%	13%	-6%	-2%

Not surprisingly, lending to commodity producers fell dramatically in the second half of 2008 and lending to weak, over-leveraged, or disappearing manufacturing and forestry sectors continued to decline. Construction and real estate development loans were strong until the third quarter, but I would expect lending to that sector to slow in Q4 and into 2009.

So who does the data side with in this argument? I'd certainly like to see the Q4 data, but absent that, it seems that the banks are already lending where they should, and cutting back in sectors where there is enhanced default risk due to a deteriorating economy.

Until I hear a better articulated argument from either the BoC Governor or the Finance Minister, I'll side with the Banks.