THEORY OF BANK CREDIT AND INDUSTRIAL GROWTH

            Some research effort has been devoted to examining the linkages between financial instability and down turns in industrial growth. One major observation is that money market booms and busts have preceded banking crises not only in developed countries (ECB, 2000). Davis 1995 but in emerging market economies as well (Collyns and Senhadji (2002), Davis (1999), Renaud (1999). Based on the above hypotheses of financial sector cycles, there are at least three dimensions of interaction between industrial growth and commercial bank credit. First, bank interest rates may affect the volume of bank credit for various reasons. From the borrowers’ point of view, changes in the interest rates of banks will have a large effect on their perceived wealth and borrowing capacity, inducing them to change their borrowing plans and credit demand (given positive

costs of bankruptcy when net worth becomes negative).

The low liquidity and interest rate volatility of various bank services/products should induce caution among borrowers in taking full account of loans for credit rises. However, from the banks’ point of view, banks have been involved in financial markets not only directly by owning investment loans, but also by providing credit that are collateralized by assets. Giving credit to property and construction companies along is one of the most procyclical and volatile elements of banks’ provisioning (Davis, 1993). Accordingly, adding these mechanisms together, changes in property prices will have major impacts on banks’ asset quality and the value of bank capital, and therefore affect banks’ credit capacity. Banks are willing to provide more investment credits and property prices are higher, generating a propagation mechanism through which credit cycles are strongly linked with each other. Such a cycle may be exacerbated by capital inflows intermediated by domestic banks, as in East Asia in the mid 1990s, as well as poor regulation (Collyns and Senhadji, 2002). 

A further complementary effect may operate via the above mentioned financial accelerator mechanism, whereby credit givers become less concerned about moral hazard and adverse selection when net worth is high, as borrowers have more to lose from default. This implies that changes in asset prices over the cycle gives rise to procyclical feedback effects of agency costs on the cost of external finance and hence on real corporate expenditures. This channel might be more powerful if banks tend to underestimate the default risk of investment related loans in a business boom and the moral hazard to which borrowers financing business investments are subject. In practice, this tendency can be the result of various factors, including poor risk management practice, inadequate data or pervasive incentives of banks, including moral hazard linked to the safety net (Herring and Wacher, 2002). Second, bank credit may affect industrial development via various liquidity effects. Changes in credit availability and credit attitudes have a sizable impact on the demand for real investment decisions, which will ultimately lead to changes in economic prices. Zhu, (2002), it has been widely documented that floods of capital seeking investment opportunities and the industrial competition among financial institutions after financial deregulation helped to stimulate the building frenzy phenomenon in a number of countries in the 1980s and 1990s, Davis (1995) and Demirgue-Kunt and Detragiache (1998), Hargraves et al (1993) note in addition that financial liberalization tends to derive the higher quality corporate borrowers  to the bond market and depositors to money funds, thus leading banks to take excessive risks to re-establish margins.

Finally, credit cycles can be driven by common economic factors. Its behaviour is largely determined by economic conditions and prospects (notably GDP and interest rates). On the other hand, the state of economic activity also exerts important forces on the money market. Changes in the business environment will cause demand and supply imbalances in commercial property and generate variations in investments and prises. These external shocks can arise from the demand side, such as changes in income. Interest rates and demographic factors; or they can arise from the supply side such as input costs as well as changes in restrictions enhancing the availability of credit or land for development (Dokko et al 1999), Chen and Patel (1998). Financial disclosure and business information transparency is a critical element in ensuring more stable capital flows. Effective debtor-creditor and insolvency regimes are critical to absorbing business failure and releasing assets for productivity use, hence bank credit are essential ingredients in overcoming industrial sector crises, IMF (2004). Commercial bank provides resources for social sector programmes to reduce the impact of poor infrastructure on industrial crises. In the Republic of Korea, banks helped the government create a financial supervisory commission and a financial supervisory service combining four regulatory agencies. Banks are helping the government support numerous small no medium enterprises, which are under stress from the financial crises, in restructuring liabilities and increasing their demand for credit. In Thailand, banks helped recapitalise other financial intermediaries, strengthen the legal and regulatory framework for the financial sector, and stress to specialized financial institutions capacity to increase credit in order to ease credit contraction. Outside East Asia, banks have provided credit or non-credits services with some degree of financial sector vulnerability, including financial sector assessment policy reviews and intensive dialogue with government authorities.

            There are many reasons why formula provision of financial services may be limited in Nigeria and other developing countries, even after liberalization. High levels of government debt have often constrained access to credit for private firms and individuals, and high inflation has discouraged saving. Poor physical and institutional infrastructure (e.g intermittent electricity supplies, inadequate telecommunications services, weak institutions for contract enforcement etc) raise the cost of provision, particularly to poor and rural areas. At the same time, poorer people have no collateral or credit record and many countries lack credit bureau, all of which serve to deter credit giving. Regulatory requirements that guard against money laundering can also make it difficult for poor people to open a bank account, as they may not have the necessary documentation. Thus widening access to financial services may simply be unprofitable in many cases. Indeed, given the many types of market failures present in financial services, the market is likely to under-provide. It is also the case that weak competition policy in some countries has results in quite a concentrated financial sector even after liberalization, allowing high spread to persist, which blunts incentives to expand access to unfamiliar and risky market segments, even where they may be potentially profitable. And a lack of detailed information about the characteristics of these market segments has made it difficult for financial institutions to correctly assess the costs and risk associated with expanding access to credit.