The rise of the commercial banking sector and household debt

The finance industry in advanced economies may be not only a source of rising income inequality but also an increasingly large part of these economies overall. A new working paper released yesterday by the National Bureau of Economic Research shows how the banking sector of the financial services industry has become larger and larger compared to the overall economy. And perhaps more interesting, the paper shows the long-run transformation of commercial banks into primarily mortgage-lending enterprises and the implications of this shift for economic stability and growth.

The paper is by economists Oscar Jorda of the Federal Reserve Bank of San Francisco, Moritz Schularick of the University of Bonn, and Alan M. Taylor of the University of California-Davis. It documents long-run changes in the level and composition of commercial bank lending for 17 advanced countries starting in 1870 and finds three major trends in the data.

The first major finding is that commercial bank credit became increasingly larger compared to the overall economy. The ratio of bank credit to gross domestic product was relatively constant during the 20th century until 1980, after which credit increased substantially. In 1980 the average ratio of bank credit to GDP among advanced economies was 62 percent. By 2010, the ratio had increased 118 percent. These results are a perfect example of financialization, or the idea the finance sector has become increasingly dominant over the overall economy.

The second finding is that increasingly commercial bank credit has shifted toward households in the form of mortgages. According to the authors’ estimates, mortgage lending was, on average, about 35 percent of all bank lending in 1970. By 2007, the year before the financial crisis, mortgage lending was closer to 60 percent of all bank lending. While the share of non-mortgage lending by commercial banks has decreased, their total amount of lending has increased enough that lending to businesses and non-mortgage lending to households has stayed relatively constant.

Put another way, increased lending by commercial banks in advanced economies has led to additional credit for households, not businesses. To be clear, this trend isn’t necessarily true for the finance sector as a whole. Commercial banks have shifted toward mortgage finance and away from lending to businesses, but investment banks, the shadow banking system, and the bond market all still provide those business services. The trend documented here is a change in the sources of different kinds of lending from the commercial banking sector of the finance services industry.

Thirdly, the authors find that mortgages are an important source of financial instability and that mortgage-lending induced crises are harder to bounce back from. Jorda, Schularick, and Taylor confirm earlier findings that increases in credit foreshadow financial crises. But their research specifically finds that increases in mortgage credit are even more predictive of crises. They also corroborate findings that recessions sparked by financial crises are more damaging than other types of recessions brought about by factors such as sovereign debt crises or sudden external shocks caused by rising energy prices. But again they find that mortgage-fueled credit booms are different and in this case more powerful, at least in the post-World War II era.

These findings may be all too obvious for Americans as the U.S. economy is still recovering from the implosion of the housing market beginning in the mid-to-late 2000s. But for advanced economies such as Canada and Australia, both of which look to be in the midst of their own housing bubbles, these results should be urgent alarms.

On a larger scale, economists and policymakers need to grapple with the results presented by Jorda, Schularick, and Taylor. If they hold true then policy toward the banking sector may very well need to be reconsidered. Commercial banks are not primarily in the business of lending to businesses so they in turn can make productive investments. Housing finance isn’t a parochial part of the banking sector. Increasingly, it is the banking sector.

September 23, 2014


Credit & Debt

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