Nova workboard

a blog from young economists at Nova SBE

A Constrained Financial System

In a text recently published in this exact platform, my colleague João Firmino [5] discussed the revisions made by Blanchard and Leigh[3]  regarding the fiscal multiplier in developed european countries, and in particular stated that “the 2008 crisis and the subsequent sovereign debt crisis severely affected the Portuguese financial system´s ability to allow agents to get access to credit and hence finance investment, and smooth consumption”. This would, as he supports, end up increasing the fiscal burden people will eventually suffer, bringing some uncertainty to the effectiveness of such austerity.

The aim of my comment is, however, a different one. I intend to briefly explain the mechanisms by which the portuguese financial system may be constrained, at the present time, and I´ll feed this statement with a few remarks from the quarterly Bank Lending Survey of the Bank of Portugal released in October 2012 [1].

To do so, let me recall Ben Bernanke [3] ´s paper “Non-monetary Effects of the Financial Crisis in the Propagation of the Great Depression”. In it, it´s argued that, as an outcome of a Banking Crisis, the Costs of Credit Intermediation (CCI´s), such as screening, monitoring and accounting increase for any given loan. The reason is quite straightforward: in a Banking Crisis, any given loan is riskier, and hence more information is required. As Banks increase interest rates, adverse selection arises, as only the riskier (the so commonly called “bad borrowers”) will stay in the market. So, and as Mishkin [6] argues, agency costs will assume a higher relevance, as it becomes more necessary to protect the “principal” from the “agent´s” risk-taking behavior. In other words, Financial Intermediaries (such as Banks) will demand a higher External Finance Premium, which, as we know will drag down the number of investments, giving rise to a “credit crunch” situation. A more detailed analysis (Mishkin [6]) may show that large corporations succeed in sustaining relatively robust growth rates in terms of total credit from alternative sources (i.e. bond sales to the public in international markets and loans obtained from banks abroad). In turn, smaller companies, whose disclosure of financial situation usually is less widespread (not being present in debt securities markets, for example), are not able to compensate the reduction in credit granted by residential financial institutions.By analyzing the situation for Portugal, we realize that the terms for approving loans have become more restrictive, which can be translated into an increase in spreads (most notably in the case of riskier loans), but also into a slight tightening of other conditions and terms. Also, it is said that overall demand for loans from enterprises shrank essentially due to decreases in fixed investment.

There are other effects on the Aggregate Demand, namely regarding consumption: for any given safe interest rate, borrowers face higher effective costs of credit, so liquidity constraints become tighter, and the share of Keynesians in our Economy increases ([4] Campbell and Mankiw). When we put this together with the degree of uncertainty agents share regarding their future, we may be confronted with a severe substitution effect (present for future consumption), that will keep on preventing us from coming back to our potential outpup. In the Survey, it´s stated that Banks expect this downward trend in consumption of both housing market and other goods to continue, which may now be connected to the recent announcements regarding the government´s budget for 2013.

Is there some sort of an expectations crisis then? It seems so. What we know for sure is that non-monetary effects can help explain the unusual length and depth of major Banking Crises, just like Bernanke argued about the Great Depression. We saw it before, and we´re seeing it now; as Banks confirm that the main reason for tightening in approval of loans and credit lines is the perception of risk, mainly regarding the general economic activity.

So, in conclusion, it´s quite likely that the current situation in Portugal may be characterized by contractions in both supply and demand for credit. One thing seems however to be certain: this crisis will not only have painful, but also protracted effects in the portuguese economy.


[1] Bank of Portugal, 2002, Bank Lending Survey, Oct. 2012

[2] Blanchard and Leigh, 2012, World Economic Outlook

[3] Bernanke, B. , 1983Non-monetary Effects of the Financial Crisis in the Propagation of the Great Depression

[4] Campbell and Mankiw, 1989 International Evidence on the Persistence of Economic Fluctuations

[5] Firmino, J, 2012. The Portuguese Fiscal Multiplier, Blog Novaworkboard

[6] Mishkin, F. (2009) The Economics of Money, Banking and Financial Markets


Francisco Farto e Abreu


Author: studentnovasbe

Master student in Nova Sbe

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