FINANCIAL MARKETS RECENT CREDIT PROBLEMS

Financial Markets Recent Credit Problems

Financial Markets Recent Credit Problems

Introduction

The current period of crisis in credit markets has highlighted the crucial role of the behaviour of banks in the transmission mechanism of monetary policy. In this regard, the recent literature stresses the role of banks' capital positions and financial innovation as major determinants of the supply of bank loans and thereby the transmission of monetary policy. This article summarizes this research with particular emphasis on recent results that highlight the key role of frictions in banking markets. In particular, these results show that bank capital, securitization and incentives for risk-taking can have a sizeable impact on banks' ability and willingness to lend.

Analysis

One of the most urgent issues for policy-makers is the impact of the current strains in credit markets on the supply of credit and, ultimately, on economic activity. In particular, the current discussion on the possibility of a credit crunch has brought the role of banks in the monetary policy transmission mechanism to centre stage in both policy and research agendas.

Until recently, the macroeconomic literature tended to ignore or overlook the role of banks as a source of frictions in the monetary policy transmission mechanism. The introduction of financial imperfections into state-of-the-art macroeconomic models to provide a quantitative assessment of the macroeconomic impact of financial intermediaries' behaviour and the financial situation of borrowers is therefore an important research topic. At the same time, empirical evidence on the traditional bank lending channel of monetary policy transmission has yielded mixed results, particularly with regard to the euro area. Recent papers provide evidence that in both the United States and the euro area banks' incentives and financial innovation play a key role in the supply of credit and the transmission mechanism of monetary policy.

Structured finance

Structured finance is a multifaceted concept. For many years, it was associated with derivative products and viewed as a fairly insignificant factor in economic and financial markets. Yet structured finance has become an important - albeit, hidden -- factor in the economy since the 1990s, and an increasingly pertinent topic of discussion since the onset of the most recent crisis.

The influence of structured finance on the trading of financial products has produced several notable effects on the organization of retail credit and financial markets, effects which are now starting to be understood and explained. For example, structured finance has improved the liquidity of transactions and the management of credit risk. These effects have varied over the recent years and have complex consequences.

Structured finance has greatly affected financial products. It has spawned the creation of increasingly complex products of all kinds, in particular those linked to the securitization of credit risk, such as CDOs. These financial products introduce sophisticated mathematical instruments and complex security and contract design that demand the collaboration of players in various disciplines. They also require high-powered computational capacities and the competent management of large databases. Because of their liquidity, these products call into question the historical methods of regulating financial ...