- Political stability
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Are new credit restrictions necessary?
submited on 19.07.2007 in category Political stability | Fiscal affairs | Monetary policy | Regulated markets | Privatisation | Macroeconomic developments
submited on 19.07.2007 in category Political stability | Fiscal affairs | Monetary policy | Regulated markets | Privatisation | Macroeconomic developments
The BNB statistics for May showed that for the first time in several years the growth of corporate credit exceeded the growth of household credit. Meanwhile, the trend towards acceleration of credit expansion in general continued. This data signaled that it is time for new restrictions on credit to be introduced. That is why it has recently been rumored that BNB considers a change in the minimal required reserves (MRR), which at the moment represent 8% of accumulated deposits. The final decision is expected to be made on the regular meeting of the Managing Board of BNB on Thursday. Undoubtedly, even if no immediate actions are taken, the issue of credit expansion restrictions will continue to be pressing in the short to medium term.
In theory there are 3 main tools of monetary policy – the so called open-market operations (buying and selling government securities), setting a certain discount rate (at which the central bank grants credit to commercial banks) and a change in the MRR. In the practice of central banks around the world the percentage of MRR is used most rarely, because it is not flexible, it is difficult to control and its efficiency depends to a large extent on the behavior of market participants. Under a currency board however, the opportunities of BNB to conduct monetary policy are almost entirely represented by the use of MRR.
The effects of the potential change of reserve requirements may be sought into several aspects. From banks’ perspective holding additional cash in the form of a non-interest-bearing deposit at BNB implies loss of potential profit. Possible restrictions of the credit expansion as a result of the increase in the required reserves will result in decline of interest revenues, which combined with the rising expenses for financing on the European interbank market will cause additional contraction in profit. In order to keep profit at the current levels or to increase them, banks will most probably try to decrease interest rates on deposits and/or increase interest rates on credit (other things equal), thus maintaining higher spread.
Let’s not forget that operating under a currency board the Bulgarian banking system continues to be strongly dependent on the recently restrictive policy of ECB. For one year only ECB raised its base interest rate by 1.25% to 4% in June 2007. As a consequence the price of credit on the intebank market in the Euro area, measured through the twelve-month Euribor, also rose and as of mid-July reached almost 4.6%. At the same time Bulgarian banks cannot finance the granted predominantly medium and long-term credit with short term deposits and thus, aiming at achieving balance in the maturity structure, continue to seek long-term financial resources from abroad, but at steadily rising price. In other words, opportunities for reduction of interest rates as an approach to attracting new credit are gradually diminishing. Potentially, the partial restriction of credit will have its impact on the behavior of credit receivers. On one hand, this measure will influence housing demand, whose purchase is often financed through mortgage credit. On the other hand, interest rates hikes could also lead to decline in investment due to non-profitability of projects with relatively low return under the new market conditions (the so called „crowding-out” effect).
It is a matter of another discussion whether at least to some extent such developments will not be neutralized by the behavior of market participants. Bulgarian banks were already operating under credit restrictions and proved that they can find alternatives to imposed credit restrictions. Bulgarian banks still continue to have easy access to relatively cheap credit from abroad (from their mother companies), despite the steady interest rate hikes in the Euro area. In this case increase in the MRR will result mainly in increase of the banking system expenses. That is why, in the medium term banks will most probably reorient towards changes in their market strategies seeking new competitive advantages (different from the offered low interest rates). Another popular opportunity for counter reaction is to make asset transformation – for example, a bank could finance another company not only through granting credit, but through purchase of corporate bonds as well. Certainly, there are also other approaches to overwhelming the impact of monetary restrictions.
On the other hand, despite the credit expansion the quality of the credit portfolio as a whole has not worsened. The share of housing credit in arrears in the total volume mortgage credit, for example, slightly increased compared to March (2.08% for March and 2.12% for May), reaching values, measured in December and January.
It is still being argued whether introducing new higher reserve requirements for the banking system will lead to loosening of inflationary pressure with the aim of following the price stability criterion from Maastricht and sooner entry into ERM II. Credit is predominantly medium and long-term and through it housing purchases and investment projects are being financed; hence, it is not highly probable for restrictions to have large impact on inflation, measured through CPI.
In theory there are 3 main tools of monetary policy – the so called open-market operations (buying and selling government securities), setting a certain discount rate (at which the central bank grants credit to commercial banks) and a change in the MRR. In the practice of central banks around the world the percentage of MRR is used most rarely, because it is not flexible, it is difficult to control and its efficiency depends to a large extent on the behavior of market participants. Under a currency board however, the opportunities of BNB to conduct monetary policy are almost entirely represented by the use of MRR.
The effects of the potential change of reserve requirements may be sought into several aspects. From banks’ perspective holding additional cash in the form of a non-interest-bearing deposit at BNB implies loss of potential profit. Possible restrictions of the credit expansion as a result of the increase in the required reserves will result in decline of interest revenues, which combined with the rising expenses for financing on the European interbank market will cause additional contraction in profit. In order to keep profit at the current levels or to increase them, banks will most probably try to decrease interest rates on deposits and/or increase interest rates on credit (other things equal), thus maintaining higher spread.
Let’s not forget that operating under a currency board the Bulgarian banking system continues to be strongly dependent on the recently restrictive policy of ECB. For one year only ECB raised its base interest rate by 1.25% to 4% in June 2007. As a consequence the price of credit on the intebank market in the Euro area, measured through the twelve-month Euribor, also rose and as of mid-July reached almost 4.6%. At the same time Bulgarian banks cannot finance the granted predominantly medium and long-term credit with short term deposits and thus, aiming at achieving balance in the maturity structure, continue to seek long-term financial resources from abroad, but at steadily rising price. In other words, opportunities for reduction of interest rates as an approach to attracting new credit are gradually diminishing. Potentially, the partial restriction of credit will have its impact on the behavior of credit receivers. On one hand, this measure will influence housing demand, whose purchase is often financed through mortgage credit. On the other hand, interest rates hikes could also lead to decline in investment due to non-profitability of projects with relatively low return under the new market conditions (the so called „crowding-out” effect).
It is a matter of another discussion whether at least to some extent such developments will not be neutralized by the behavior of market participants. Bulgarian banks were already operating under credit restrictions and proved that they can find alternatives to imposed credit restrictions. Bulgarian banks still continue to have easy access to relatively cheap credit from abroad (from their mother companies), despite the steady interest rate hikes in the Euro area. In this case increase in the MRR will result mainly in increase of the banking system expenses. That is why, in the medium term banks will most probably reorient towards changes in their market strategies seeking new competitive advantages (different from the offered low interest rates). Another popular opportunity for counter reaction is to make asset transformation – for example, a bank could finance another company not only through granting credit, but through purchase of corporate bonds as well. Certainly, there are also other approaches to overwhelming the impact of monetary restrictions.
On the other hand, despite the credit expansion the quality of the credit portfolio as a whole has not worsened. The share of housing credit in arrears in the total volume mortgage credit, for example, slightly increased compared to March (2.08% for March and 2.12% for May), reaching values, measured in December and January.
It is still being argued whether introducing new higher reserve requirements for the banking system will lead to loosening of inflationary pressure with the aim of following the price stability criterion from Maastricht and sooner entry into ERM II. Credit is predominantly medium and long-term and through it housing purchases and investment projects are being financed; hence, it is not highly probable for restrictions to have large impact on inflation, measured through CPI.
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