Loan rates as a selective credit control

Journal of Banking and Finance 8 (1984) 79-98. North-Holland

LOAN RATES AS A SELECTIVE CREDIT CONTROL Lazaros E. MOLHO* Fordham Uni~'ersity, Bronx, N Y 10458, USA Received September 1982, final version received July 1983 When the monetary authorities set interest rates above or below market-clearing levels, loan markets are in disequilibrium. The success of a policy that is aimed at favoring some sectors of the economy with relatively low loan rates depends on the state of the various loan markets. That policy will be most definitely effective when loans to the favored sector are in excess demand while other types of loans are in excess supply. It may be tess successful when all loans are in excess supply and counterproductive when they are in excess demand.

1. Introduction The effectiveness of selective credit controls has been discussed in several theoretical studies. Rao and Kaminow (1973) have employed a general equilibrium model of the financial sector to determine the conditions under which selective reserve requirements on bank assets can influence the composition of real investment. Success of such a scheme was found to depend on the degree of substitutability between different types of real assets and the relative interest rate sensitivities of different financial instruments. Penner and Silber (1973) have shown that the impact of interest rate subsidies and portfolio restrictions on banks depends not only on the substitutability between different types of securities but also on whether there is an unrestricted sector of the financial market. Cotula and Padoa-Schioppa (1971) have discussed the effects of ceilings on commercial bank loans or total bank assets on the structure as well as the level of interest rates. One common feature of all these studies is that whatever restriction is imposed on financial institutions, ultimately all financial markets clear as interest rates are free to adjust. In many countries, the banking system is tightly controlled by the authorities and interest rates on loans and deposits *This paper is an adaptation of a chapter of my doctoral dissertation (Monetary Policy and Selective Credit Controls in Greece, Yale University, 1980). I am indebted to Professors William Brainard, William Keeton and two anonymous referees for their valuable criticisms and suggestions. I am solely responsible for any remaining errors. 0378-4266/84/$3.00 9 1984, Elsevier Science Publishers B.V. (North-Holland)

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L.E. Molho, Loan rates as selectire credit control

are administered. This may generate persistent financial market disequilibria that cannot be analyzed in the context of equilibrium models. The purpose of this paper is to extend the Rao and Kaminow approach to analyze the impact of loan rates as a selective credit control in a general disequilibrium model. Kaminow and O'Brien (1975, pp. 14-19) have informally suggested a way to study financial market disequilibria as special cases of a more general model. In such a spirit, we derive the properties of our model for three cases with different types of loan market disequilibria. Our results are found to depend crucially on (a) which particular markets are in excess demand or excess supply, and (b) the nature and size of the spillovers of any disequilibria into other markets. The motivation for this analysis is the Greek financial system, in which most funds are allocated through the highly regulated banks. The authorities set high interest rates on loans that finance activities to be discouraged and low rates on loans to favored sectors of the economy. The efficacy of such a policy has already been questioned [e.g., Halikias (1978)] on the grounds of the possibility of perverse loan supply effects. The conditions under which the policy will be effective are derived in a more formal and systematic way in this paper. This paper consists of 4 sections. Section 2 gives a brief description of the basic features of financial markets and the process of monetary control in Greece. In section 3 we develop our theoretical model and derive the results. Finally, in section 4 we present our conclusions and discuss the usefulness as well as the limitations of our approach.

2. Financial markets and the conduct of monetary policy in Greece ~

The Greek capital market is not well developed. Big industrial firms that are credit worthy enough to market their securities are generally reluctant to do so. 2 The family character of most of these firms and the unwillingness of the owners to dilute their stock may account for their aversion to equity financing. This attitude may be reinforced by the easy access of large firms to artificially cheap bank credit) On the demand side, the dividend policies of family owned firms and the low level of activity in the stock market may make stocks riskier and less attractive stores of value than bonds or bank deposits.4 The banking system, which is the major channel of funds from surplus to 1For a fuller account on these issues, see Bitros (1981), Halikias (1978), Psilos (1964) and Zetrides (1973). 2Bank of Greece (1976, p. 62). 3Halikias (1978, pp. 202-203). 4Psilos (1964, pp. 69-112).

L.E. Molho, Loan rates as selectire credit control

81

deficit units, 5 consists of the central bank, a number of state-controlled specialized credit institutions, several commercial banks, and two private investment banks. The central bank is the source of funds for the specialized credit institutions, which provide loans to agriculture, long-term loans to industry, housing loans to low-income groups and public employees, and loans to public utilities. Commercial banks extend loans to all sectors of the economy other than agriculture and housing. Most of their liabilities consist of various types of deposits. Finally, the private investment banks, which are controlled by the two major commercial banks, engage in long-term financing and participation in the equity capital of industrial enterprises. In the absence of a well developed capital market the central bank is unable to conduct significant open market operations without altering the prices of the traded securities considerably.6 The rediscount rate, which applies to commercial bank borrowing from the central bank, is also an insignificant instrument of monetary policy. Commercial banks rarely resort to the Bank of Greece for funds as the growth of deposits and reserves usually allows them to meet their obligations with their own funds.7 Monetary policy in Greece consists of a system of qualitative and quantitative controls on the portfolios of financial institutions. These controls are designed to influence the volume as well as the distribution of credit across different sectors. The authorities determine the portfolio policies of specialized credit institutions directly. Commercial banks, which are the most important source of credit, are controlled less directly through an elaborate system designed to affect the liquidity and the disposition Of their funds. In particular, commercial banks are required to hold specified fractions of various types of deposits in reserves, treasury bills, and government bonds. Also, fractions of all drachma deposits have to be invested in various types of long-term assets and loans. Interest rates on bank deposits and loans are subject to ceilings which are effective most of the time. The rates are set so as to make credit for high-priority activities cheaper than credit flowing into what are considered less productive sectors. Since 1966, this interest rate differentiation has been combined with a system of asset reserve SThe total value of all security issues in Greece averaged less than 12.5 percent of the total flow of bank credit over the decade 1968-1977. In the same period, funds raised in the securities markets by the private non-financial sector represented less than 4 percent of the flow of bank loans to private manufacturing firms. Compared to other OECD countries, Greece had by far the lowest ratio of security issues to GDP in that period. This ratio was 0.78 percent for Greece and ranged from a low of 2.65 percent (France) to a high of 11.42 percent (Netherlands) for all other OECD countries. Similarly, in 1976, net security issues amounted to a mere 12.2 percent of the increase in time and savings deposits with financial institutions in Greece. The corresponding figures were 320.2 and 275.9 percent for the United States and United Kingdom, respectively I-OECD, Financial Statistics, 1978, Vol. 12, part I, 1MF, International Financial Statistics, 1978, Supplement, and Bank of Greece (various issues)]. ~Dorrance (1965, p. 274) and Park (1973, p. 400). 7Bank of Greece (1972, p. 87).

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L.E. Molho, Loan rates as selectire credit control

requirements-reserve withdrawals that are designed to equalize the nominal rates of return on different loan types from the point of view of banks. Finally, the monetary authorities determine the terms and conditions under which commercial banks can extend certain types of loans. In some cases, maximum loan sizes as well as ceilings on the overall expansion of bank credit are set. The state is the major shareholder of the two largest commercial banks that control 90 percent of commercial banking activity. In principle, the government may exercise some direct control over these banks' portfolio policies by appointing their top administrators. In practice, these policies are determined by lower level bank executives, who are career bankers and whose promotion depends on their success in attracting deposits and extending riskless loans. Thus competition for the acquisition of safe, highyielding assets may be fierce even between different branches of the same bank and may induce bankers to violate credit regulations,s The authorities' loan rate policy is a good example of the possible conflict of interest between bankers and the government. This policy consists in specifying low rates on loans for high-priority activities, such as export trade and industrial investment, and high rates on less desirable activities, such as import and domestic trade. The aim is to affect the composition of loan demand and expenditure by the private sector. From the point of view of banks, however, this interest rate structure clearly favors the supply of highyielding loans. The net effect of such loan rate differentiation on output composition is thus ambiguous. In the following section, ' we develop a model of the financial sector to derive conditions under which this type of loan rate policy will be effective. The effects of compensating asset reserve requirements-reserve withdrawals on our results are discussed informally. 3. A model of the financial sector

Consider an economy in which wealth can be held in two physical assets H and K and two liquid assets D (deposits) and C (currency) bearing rates of return rh, rk, r a and 0, respectively. 9 Wealth owners who wish to hold assets in excess of their net worth may obtain two types of loans Lh, Lk at interest rates ~, ~, respectively. Lh and L k are presumed to finance the purchase of the corresponding physical assets H and K, respectively. However, wealth owners may be free to use their funds as they like. In the general form of the model we allow for use of both types of loans in the purchase of each one of 81 am indebted to a retired executive of the National Bank of Greece for this information. 9The absence of a variei-y of financial assets is a feature of most less developed countries. The asset choice of wealth owners is then restricted to money or physical assets [Park (1973, p. 390)1.

L.E. Molho, Loan rates as selective credit comrol

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the four assets. Loans are extended by financial intermediaries whose liabilities consist of wealth owners' deposits D. 1~ The deposit rate is fixed by the authorities and, as long as the loan rates exceed this rate by a margin large enough to cover the costs of intermediation, banks are willing to take all the funds deposited with them. Banks are required to hold a fraction ct of their deposits as reserves. We assume that each one of the public's asset and loan demand functions is homogeneous of degree one in wealth and depends on the interest rates on all assets and loans. We denote these notional demand functions with an asterisk. The banks' loan supply functions LL L~, depend on the loan rates ~ , ~ . Letting Ho, Ko, Co denote the predetermined supplies of the two physical assets valued at replacement cost and high-powered money, as fractions of net private wealth, respectively, and f=(rk, r~,~, ~) we can write down the equilibrium conditions for the financial sector of the economy, 11 H*(0=Ho,

(1)

K*(0=Ko,

(2)

C*(O+c~D*(O=Co,

(3)

L~,(~, ~, ( 1 -- ~x)D*)+ L~'(r')= 0,

(4)

L[(~, ~, (1 -cOD* ) + L~(f) =0,

(5)

( 1 - cOD*(f)--L~(~, ~, (1--~)D*)--L[(~,~, (1--~)D*) =0.

(6)

Adding up eqs. (1)-(6) we obtain H*(F)+K*(f)+C*(f)+D*(F)+L*(f)+L*(f)=Ho+Ko+Co=I,

(7)

which is the wealth constraint for this economy. Note that the homogeneity of the asset demand functions implies that the level of wealth does not matter and allows us to write the equilibrium conditions in terms of fractions of net private wealth. Also, our model, which is one of beginning-of-period or stock equilibrium, allows us to consider the financial sector independently of the goods market in the spirit of the 1~ banks are the sole suppliers of credit to the private sector in our model. This does not preclude central bank borrowing from abroad but ensures that the effectivenessof selective credit controls will not be undermined by foreignlenders. t tThis model is an extension of the Tobin and Brainard (1963)model.

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L E . Molho, Loan rates as selectire credit control

standard IS-LM model. 12 Thus, we can discuss financial market equilibria and disequilibria irrespective of the state of the real sector of the economy letting any excess demand for loans spill over exclusively into the other asset markets.t3 In order to simplify the analysis, we assume that the authorities manipulate the required reserve ratio a so as to keep the volume of banks' disposable funds fixed at a level L. This allows us to focus on the effects of selective policies that are aimed at reallocating funds between sectors without affecting total credit to the economy. 14 Substituting ct= 1-L/D*(f) in (3) and (6) yields

c*(~) + D*(e)- L = Co,

(3')

L--L[(~,~)--L[(~,~)=O.

(6')

Substituting (6') for L~, in (5) and omitting (3') by the wealth constraint we are left with four equations in four unknowns rk, lh, ~, r~, H*(f) = H o,

(1)

K*(f) = K o,

(2)

L~(~, ~) + L~'(f) = O,

(4')

L--L~(~,~)+L*(f)=O.

(5')

1=For a detailed discussion of the differences between beginning-of-period or stock equilibrium and end-of-period or flow equilibrium models, see Patinkin (1958) and Foley (1975). Patinkin (1958, p. 306) argues that 'if the periods presupposed by the analyses are the same, the excessdemand function of stock analysis must be identical with that of flow analysis'. Foley (1975), on the other hand; argues that this assertion is valid only under very restrictive conditions and that the two versions of asset equilibrium are consistent with each other only when agents have perfect foresight of near future prices and interest rates. laThis would not be possible in a flow model in which Walrus' law holds between goods and asset markets [Foley (1975, pp. 323-324)]. The implicit assumption of our stock model is that all existing assets are at least potentially on the market at any time while only a small fraction of existing assets is on the market at any time in flow models [Foley (1975, p. 319)]. Our assumption is plausible since physical assets may be financed with revolving short-term credit which is renegotiated each period. Also, loan contracts may require prepayment in full in case of sale of the physical assets that are credit financed. The nature of our stock model allows us to maintain the separation of asset and goods markets in disequilibrium as well as in equilibrium. In the IS-LM model, for example, any amount of excess demand for money is fully reflected in an equal amount of excess supply of bonds leaving the goods market unaffected. Similarly, our model allows us to study the effects of financial market disequilibria in isolation from the goods market. 14Although reserve requirement changes are rarely used as an instrument of monetary control in the U.S., it is common practice to regulate bank liquidity by varying the required reserve ratio in countries with less developed financial markets [Dorrance (1965)].

I_.E. Molho, Loan rates as selectiL'e credit control

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We assume that all assets (including the asset loans) are gross substitutes in wealth owners' portfolios, is Thus, the asset demand functions are positively related to the own rates of return and negatively related to all other rates. The bank loan supply functions are also assumed to be positively related to the own loan rate and negatively related to the other loan rates. The two types of loans may be imperfect substitutes from the point of view of both lenders and borrowers. Lenders may associate different types of projects with different risks of default. For example, loans that finance purchases of real estate or import trade may be considered much safer than loans that finance industrial investment. The high level of activity in the real estate and import markets and the consistently high profitability of transactions in these markets may be an adequate assurance to lenders that loans to these sectors are of good quality. Manufacturing industry, on the other hand, has not been as lucrative as the above activities. The market for used machinery and equipment is not nearly as well organized and active as the real estate and import markets. Thus, if industrial investment fails to yield the expected profits, the borrower may have difficulty repaying the loan. Put in other words, loans that finance lucrative activities may bear a lower administrative cost from the point of view of banks to the extent that less effort is needed to establish the credit worthiness of the customers. From the point of view of borrowers, the two types of loans will be imperfect substitutes if banks monitor the use of borrowed funds. Borrowers that are restricted in the use of their funds will be able to shift funds across sectors only to the extent that they can free their own resources that were previously designed to be channeled to the credit financed project. Moreover, even if banks are willing to let credit worthy borrowers use bank funds as they please, borrowers may be constrained for fear of the monetary authorities' penalties for misuse of bank credit. The impact of selective credit controls is judged on the basis of their effect on the required rates of return rh and rk. These rates determine the profitability of investment opportunities and thereby the volume of investment in each sector. 16 l~The physical assets K and H are assumed to be imperfect substitutes as a result of differences in characteristics such as risk, divisibility, liquidity, transaction costs, and taxes. 16The assumption is that the marginal productivities of H and K are fixed so that any change in the required rates of return rh and rk will change the market valuation of the stocks of H and K relative to replacement cost and thereby the profitability of investment. For a detailed discussion of this type of transmission mechanism, see Tobin and Brainard (1963) and Tobin (1969). In the long run, of course, it is reasonable to expect that the required rates rh and r~'will be equal to the marginal productivities of H and K, respectively. In the short run, however, monetary and other types of disturbances may change asset demands generating a disparity between rk and r~ and the corresponding marginal productivities. This will tend to affect the rate of accumulation (or decumulation) of K and H until that disparity is eliminated. Consider, for example, a factory with a replacement cost of $100,000. Suppose that originally the market value of its stock is also $100,000 so that the return to stockholders and the marginal physical productivity of the factory are equal. Consider now a monetary expansion that lowers bond

L.E. Molho, Loan rates as selective credit control

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In general, when the authorities set the loan rates ~ and ~, the two loan markets are in a state of disequilibrium. We assume that in such a disequilibrium situation, the volume of funds that are actually lent is equal to the minimum of the amounts demanded and supplied. This is a reasonable assumption since agents cannot be forced to borrow or lend more than they want to. Types of financing that are to be discouraged bear high rates, while low interest rates are set for credit to favored sectors. The purpose is to stimulate investment spending in the high priority sectors of the economy. The effectiveness of such a policy depends on the state of the loan markets. Interest rate manipulation is aimed at affecting borrowers' demand for funds. If borrowers are not on their notional demand for loans to begin with, this policy will have little effect on actual borrowing. Moreover, if credit supply varies with the loan rate, a lower rate will lead to a credit contraction. On the other hand, if loan supply exceeds demand, lowering the cost of credit will have the expected expansionary effect on actual borrowing. This argument can be applied to our model of two physical assets and two corresponding types of loans. The loan rates f~, fzh are set by the government. We distinguish three cases depending on the original state of the two loan markets: (a) both loan types are in excess supply; (b) one loan type is in excess demand, the other one in excess supply; and (c) there is excess demand for both loan types. We analyze the effects of loan rate changes separately for each case.

(a) Excess supply in both loan markets The system of eqs. (1), (2), (4'), (5') can be rewritten as

U*Crh,

(8)

K*(rh, rk;fk, e~)=Ko,

(9)

L~(f~,~)+L*(r,,rk; f~, ~lh)> O, L - L~(q, ~) + L *(rh, rk;q, ~) > O.

(lO) (11)

yields increasing demand for stocks and thereby stock prices. The market value of the factory ~ill rise, say to S120,000, and the dividend-price ratio will fall. If the factory's marginal productivity has not changed, it will be profitable for arbitrageurs to buy new factories at $100,000 and sell them in the stock market for $120,000. This process will go on until there are enough factories to restore equality between market value and replacement cost or, equivalently, between the rate of return on the factory's stock and its marginal productivity. The important point, for our purposes, is that given the marginal productivity of capital, financial market conditions may affect the rate of capital formation through their effect on the community's required rates of return on titles to physical assets.

L.E. Molho, Loan rates as selective credit control

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The equilibrium rates of return rh, rk are determined by eqs. (8) and (9). In both loan markets banks can only lend as much as borrowers demand. Their effective loan supply is equal to the borrowers' demand for loans. The disequilibrium is wholly absorbed by banks in the form of unwanted accumulation of excess reserves. Solving for the effects of changes in the rate ~ we find that, in general, both rh and r~ move in the same direction as ~ but the effect on rh is stronger than the effect on rk. Thus loan rate changes have the anticipated selective impact, in general. Only in the special case in which high-powered money is a relatively much closer substitute to K than to H is it possible for a change in ~ to affect rk more strongly than rh. To see how this can happen, note that a rise in ~ results in excess supplies of H and K but excess demand for high-powered money. Even if the excess supply of H is larger, the excess supply of K will be exacerbated by the excess demand for money and rk may rise more than rh. Finally, in the extreme case of no substitutability between K and H (aK*/drh=aH*/ark=O) and no leakages of loans across sectors (aK*/a~=dH*/a~=O) changes in ~ affect only rh leaving rk unchanged. Under these conditions, it is obvious that the loan rate policy will be effective irrespective of the properties of the demand for high-powered money. 17 (b) Excess supply in one loan market and excess demand in the other one In this case borrowers are rationed in the excess demand loan market. The aggregate demands for the other assets will differ from the corresponding unconstrained demands as the loan market disequilibrium spills over into these markets. Thus, if demand for Lh exceeds supply, effective demand for K and H will be lower than the corresponding unconstrained demands. Some of the disequilibrium may also be absorbed by demand for the other type of loans Lk and demand for liquid assets increasing the former and decreasing the latter. On the supply side, lenders will also be constrained to the extent that demand for one type of loan falls short of the quantity of loans they are willing to extend. We assume that this excess supply is fully absorbed by the other loan market in which there is excess demand for loans. 18 Thus, there is a tendency for the two loan market disequilibria to mitigate each other. In one market, the excess demand is reduced as lenders add to the supply of funds the unused funds of the other market. In the other market, the excess supply of funds fails as borrowers increase their loan demand because they are unable to borrow enough in the excess demand market. Letting H, K, Lk denote the effective demand functions for the two ~TThe derivation of these results is given in the appendix. tSThe assumption is that banks lind lending to the excess demand sector more profitable than holding free reserves. J.B.F. D

L.E. Molho, Loan rates as selective credit control

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physical assets and one type of loans when there is excess demand for the other type of loans we can write down the system's equilibrium conditions,

H(rh, r~,L~r ?hl,?~)=Ho,

(12)

K(rh, rk, L~h';Fh,fk)= Ko,

(13)

-h -k L[ (~, ~) + L k, (rk, rh,. rz, rt) > O,

(14)

L-- Lk (rt, rt) + Lk (rk, rh, rt, rt) < O,

(15)

--

s

-k

-h

,

. -

-

where the effective supplies of loans L~,~,L~c are given by

L~~+ L~(r~,rh, L~; ~h,•) = O,

(16)

L~'= L - L~kr

(17)

We assume that all effective asset demand functions have positive own rate and negative cross rate partials and are unaffected by changes in the rate on the loan that is in excess demand. In this case, there is a feedback relationship between the two effective loan supplies L~,c and L[c. The effective supply L~,c is equal to the corresponding effective demand as long as this sector remains in a state of excess supply. The funds that cannot be lent out in this sector flow into the excess demand sector. An autonomous increase in the demand for loans Lk will give rise to an equal increase in L~,~ and a decrease in L~,* of the same magnitude. The excess demand for Lh will rise and borrowers will demand more Lk to alleviate the shortage in the excess demand sector. This will induce a rise in L~,~, a fall in L~," and a further increase in Lk. The process will continue until eqs. (16) and (17) are satisfied. The coexistence of excess supply and excess demand loan markets may make the system unstable. When Lk and L h a r e sufficiently close substitutes, any disturbance will stimulate a massive increase in Lk that will eliminate the excess supply in this sector. The system will then degenerate to one of excess demand in both loan markets [the situation described under case (c)]. A necessary and sufficient condition for stability is

OLk/OUh~< 1.

(18)

This condition insures us that excess demand for L h does not affect solely demand for Lk but spills over at least in part into other asset markets. If the system is stable the authorities may be able to stimulate investment in physical assets selectively. A rise in fk will decrease demand for Lk and

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thereby L~e. Banks will increase L~/to dispose of their idle funds and this will tend to raise the effective demands for K and H. On the other hand, the rise in f~' will tend to decrease K and H. If each one of the two physical assets is relatively closely associated with the own type of loan and if some of the excess demand for Lh spills over into the market for liquid assets, then the ultimate effect of the rise in f~ will be to stimulate investment in H and decrease investment in K. A rigorous derivation of these sufficient conditions is given in the appendix.

(c) Excess demand in both loan markets Now the effective asset demand functions depend on both loan supplies L~, and L~,, which are independent of demand conditions. Banks are on their notional supply schedules and supply of each loan type is positively related to the own loan rate and negatively related to the other loan rate. The properties of the effective asset demand functions are assumed to be the same as in case (b) above. We have

H (rh, rk, L~, L~; f~, ~) = Ho,

(19)

K(rh, rk, L~h,L~; ~ , ~ ) = Ko,

(20)

L~ = L~(f~, ~),

(21)

s -h -k Lks = L~ - - Lh(r , , r,),

(22)

Lg + L*(rh,

(23)

+ L (rh,

(24)

We can determine the effect of changes in ~h, ~k by solving the system of eqs. (19)-(24). The solution is given in the appendix. We assume that the effective demand for H is more sensitive to L~, than it is to L~ and that the effective demand for K is more sensitive to L~ than it is to L~,. This is a reasonable assumption. One would expect, demand for housing to be more closely related to the supply of mortgages than it is to the supply of corporate loans. Thus, we have

aH/aL[ < OH/aLg,

(25)

8K/SL~,< 8K/SL[.

(26)

and

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L.E. Molho, Loan rates as selective credit control

It follows that raising the loan rate ~ will never have the desired selective effect of stimulating investment in H and decreasing (or leaving unchanged) investment in K. Moreover, in the absence of any perverse spillover effects on currency and deposits, i.e., if OC]OL~k= aC/OL~h and

OD/OL[= OD/OL[,

(27)

raising ~k changes the investment mix in favor of K. This is because loan rate changes have no direct effects on effective asset demands as long as the two loan markets are in a state of excess demand. Banks, on the other hand, are on their notional supply schedules and loan rates will affect the composition of their portfolios. Thus, a rise in ~ leads to a rise in L~, a fall in L~ and thereby an increase in the effective demand for K and a decrease in the effective demand for H. Investment spending, then, increases in the sector in which credit became more expensive.

4. Concluding remarks The effects of changes in loan rates on the real investment mix can be analyzed in the framework of a model of the financial sector with two physical assets and two corresponding types of loans. The authorities manipulate the two loan rates with the aim of affecting the composition of investment in the two physical assets. The effects of this interest rate policy depend crucially on the original state of the two loan markets. A policy of low rates on loans to the favored sector and high rates on loans to the low-priority sector is most likely to be effective when there is excess demand for the former and excess supply of the latter. The policy may fail to work otherwise and may be counterproductive if both loan markets are in a state of excess demand. One practical implication of our results is that loan rate differentiation can be effective when the margin between the two loan rates is wide enough to allow for excess demand on one 10an market to coexist with excess supply in the other one. A necessary condition for stability in this type of situation is less than 100 percent spillover from the excess demand to the excess supply loan market. In the particular case of Greece, loan rates have been low relative to the rate of inflation in recent years and most loan markets may have been in excess demand rendering the loan rate policy ineffective. In 1966, the authorities became aware of the possible impact of perverse loan supply effects and implemented a system of asset reserve requirements to make all loans equally profitable from the point of view of banks. The analysis of the previous section can be extended to account for this policy. Instead of looking at ceteris paribus changes in the two loan rates we can consider compensated variations with asset reserve requirements and the

L.E. M o l h o , Loan rates as selectire credit control

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supply of high-powered money varying so as to offset the effects on notional loan supply and the demand for reserves. Such compensated variations of the loan rates can no longer generate perverse results of the type that may arise when both loan markets are in a state of excess demand. In the absence of loan supply supply effects loan rate changes will be unable to alter the composition of real investment. For the two other cases, namely the case of two excess supply loan markets and the case of one excess demand and one excess supply market, the results of the last section remain valid when compensatory reserve requirements are imposed. These requirements can affect banks' notional loan supply functions, but have no effect on effective supplies when banks cannot attain their desired portfolio. The relevance of our approach is not restricted to the case of Greece. In less developed countries, prevailing loan rates are artificially low and credit rationing is a very powerful source of transmission of monetary policy to the real economy. 19 Our theoretical model provides a useful formalization of this transmission mechanism. Empirical estimation of our asset demand functions is a very difficult task as the required rates of return on physical assets are unobserved variables. Our model is still useful from an econometric point of view providing a rationale for the inclusion of loan supplies as explanatory variables in investment expenditure equations. Inclusion of such variables will yield consistent ordinary least squares estimates only if the loan markets in question are in a state of excess demand. In all cases the estimates ought to satisfy the implied cross-equation adding up restrictions on spillover coefficients.2~ In concluding, we discuss some limitations of our analysis. One shortcoming of the Tobin and Brainard (1963) approach and the model of this paper is the assumed exogeneity of asset supplies. In general, a fall in the required rate of return on capital will increase the market value of the capital stock and thereby net private wealth [Tobin (1969)]. We can incorporate such effects in our model by allowing Ho, Ko and C O to be functions of r h and r k. Then a fall in rh will raise H o at the expense of K o and Co and, similarly, a fall in r k will raise K o at the expense of Ho and Co. This will leave the signs of the partials of the excess demands for H, K and C unchanged as it reinforces the partials of the respective notional demand functions. Thus, accounting for wealth should not alter our comparative static results qualitatively. With respect to the properties of our unconstrained and effective asset demand functions, gross substitutability is a plausible assumption but our results do not necessarily hold for other types of demand functions. Also, our assumption that the authorities adjust reserve 19park (1973, p. 394). 2~ and Tobin, 'Pitfalls in Financial Model Building',in Tobin (1971, p. 365).

92

L.E. Molho, Loan rates as selectire credit control

requirements continuously so as to keep credit constant may be unrealistic. If the stock of high-powered money is the only policy target, then a rise in any loan rate will lead to decreases in deposits and total credit in addition to altering the composition of loan demand and supply. 2~ This credit supply effect will not matter when both loan markets are in excess supply, but will increase the excess demand for loans in the other two cases making the results a little more ambiguous. More generally, the stylized versions of financial markets of the previous section that were aimed at assessing the efficacy of loan rate policy are not close to a full representation of the workings of these markets. As was pointed out in section 2, the Greek government has full control over the operations of specialized credit institutions and can thus determine directly the flow of funds to sectors such as housing, agriculture and, to some extent, industry. In addition to interest rate controls, commercial banks are subject to ceilings or even total prohibition of certain types of financing. As a result, the Greek financial markets are in a state of chronic disequilibrium and, on some occasions, it is very hard to determine which side of the market absorbs the disequilibrium. For example, a bank may be willing but unable to extend loans at terms acceptable to borrowers as a result of credit regulations. This may lead to the simultaneous presence of excess demand and excess supply in th~ same loan market with both lenders and borrowers off their notional schedules. Finally, it is difficult to determine which controls are evaded and the extent of such evasion. The effectiveness of selective credit controls can surely be enhanced by making incentives for bank executives consistent with the authorities' broader policy goals.

Appendix (a) Both loan markets in excess supply Solving eqs. (8), (9) we obtain expressions for rk, rh in terms of the exogenous rates ~, ~. The Jacobian J l of the system of eqs. (8), (9) is

(os-S*lO, oFS',lO, ' Jl=\dK*/drh

OK*/Ork,]"

J1 has positive diagonal elements, negative off-diagonal elements and positive column sums. It follows that the determinant of J l is positive. Solving for the effects of a change in ~h on rh, rk we obtain ~llf total liquid assets (currency and deposits) and the policy target, then loan rate changes will not affect total credit supply unless they result in a different currency--deposit ratio.

L.E. Molho, Loan rates as selectire credit control

OH* OK*

~H*

d~ =

drh

Or';, Or-W+ 3,', ~,

drk

OH* OK*

OH*

[ ~= [

~ I.s,l>0, '"']/

Or, Or + Or ~

93

(A.1)

I'S'I>o"

(A.2)

To determine the relative strength of the effects of a change in ~ on rh and rk we subtract (A.2) from (A.1) and obtain

drh/d~-drk/d~>O

r

(aH*la~)/(aH*/arh)

(A.3) 1 +(aH*/&,)/(aH*/Orh) 1 + (OK */Orh)/( OK */Ork)"

>

(A.4)

The left-hand side of (A.4) will be greater than one if demand for each physical asset is relatively more closely related to the interest rate on the loan associated with this asset. Then a sufficient condition for (A.4) to be valid is

dH*/drk < OK*/Orh < 0. OH*/Orb =-@K*/Ork

(A.5)

Note that total demand for high-powered money B* now consists of the public's demand for currency and banks' demand for required and excess reserves. Thus, eq. (3) becomes B* = C* + aD* + [(1 - a)O* + L* + L~'] = C* + D* + L* + L* = Co.

(A.6)

The balance sheet constraint (7) then implies

OH* 0rk

OK* ark

OB* 0rk

and

OK* 0rh

OH* Orb

~B* Orb

(A.7)

To interpret (A.5) we substitute (A.7) for OH*lark and dK*/drh and note that for given values of aH*/arh and ~K*/Ork the substitutabilities between each physical asset and high-powered money are crucial. Inequality (A.3) is violated only if OK*/Orb is a relatively much larger negative number than aH*/Ork. Thus, a perverse effect of an increase in ~ is possible only when high-powered money is relatively much closer to K than it is to H.

94

L.E. Molho, Loan rates as selectire credit control

(b) One loan market in excess demand, the other one in excess supply

We have a system of four equations in four unknowns (rk, rh, L~kc, UhC). We assume that the own rate partial derivatives of the effective asset demand functions K, H, Lk are positive and the cross-rate partial derivatives are negative. We also assume that the spillover coeffieints aH/OL~h~, OK/OL~h~, aLk/aUh ~ are all non-negative and smaller than or equal to one. Partials with respect to fh are assumed equal to zero. We can substitute for L~,* in terms of (16), (17) in eqs. (12), (13) and obtain a system of two equations in two unknowns. We have H (rh, rk, rl) = Ho,

I

.-k

(A.8)

K,(rh, rk; fk) = Ko,

(A.9)

where OK' Or

OK Or

OK OL~~ OL~h* Or

OH' Or

OH Or

OH OL~~ ., OL~~ Or

OL~~

OLk/Or

Or

1 -- OLk/OL[ ~

(A.10)

r=rh, rk, f~.

(A.11)

(A.12)

Substituting for OLaf~Or in terms of (A.12) in (A.10), (A.11) yields OK' OK --=--q dr ar

OK/OL~ ~

OLk

1--aLk/aL~h ~ dr '

OH' OH OH/OL~h" OL k Or =--~-r q 1--OLk/OL~h ~ Or '

(A.13)

(A.14)

for r=rh, rk, r~. A necessary and sufficient condition for the system of equations (A.8), (A.9) to be stable is that OLk/OL~h ~ <

I.

(A. 15)

This condition guarantees that the excess demand in one loan market does not spill over exclusively into the other loan market. If (A.15) is satisfied, then our assumptions on the partials of K, H, L k imply aK'/arh < 0,

(A. 16)

L.E. Molho, Loan rates as selective credit control

OH'lark <0.

95

(A.17)

Moreover, if

OKIOL~h~+ OHIOL~h~+ OLffaL~h~< 1,

(A.18)

OK'/drk > 0,

(A. 19)

OHTarh > 0,

(A.20)

then

and the determinant of the Jacobian of the system of (A.8), (A.9) is positive. Condition (A.18) requires that some of the excess demand for Z h spill over into the market for liquid assets (C and D). Finally, from (A.13), (A.14) it follows that, in general, the signs of OK'/Of,~, OH'/O~ are ambiguous. If each one of the two physical assets is relatively closely related to the loan associated with it, i.e., if

OH/O~ < OLk/O~ OH/OL~< 1-OLffOL~h" <

OK/Of~ OK/OL~c'

(A.21)

then dK'/a~ < O,

(A.22)

OH']O~ > 0.

(A.23)

and

Solving for the effect of a change in fk on rh, rk we let

d

[att'/arh

OH'/ark~

OK'/arU' and obtain

drh=(

an'OK'

OH'OK"X]..

drk=(

OH'OK'

all'OK"\/,, ~rh )/jJ2[.

d~

~ Orh 0 ~ t ~

(A.24)

(A.25)

If conditiQns (A.18) and (A.21) are satisfied then

aHTOrk - < aK70rk

-

aHTa~ - - < OKTa~

-

OH'/Orh OK'/arh

guarantees that drffdf k < 0 and drk/d~ k > O.

(A.26)

I.E. Molho, Loan rates as selective credit control

96

(c) Excess demand in both loan markets We can substitute (21), (22) for L~,, LI, respectively, in (19), (20) and obtain

H"(rh, rk; r~, ~) = Ho,

(A.27)

K"(rh, rk; ?~, ~) = Ko,

(A.28)

OIl"/Or = OH/Or,

(A.29)

OK"/Or = OK/Or,

(A.30)

where

for r = r h, rk and

OH" Or

OH OH OL'h OH OLd, -I- - - - § ---Or OL~h Or OL[ Or

OK" OK OK OL'h OK OL[ Or = O r JrOL~ Or § Or '

(A.31)

(A.32)

for r=f~', f~. To determine the effect of changes in ~k on the rates rh, r k we let

(OH/Orb J3=\OK/Orh

OH/Ork~ OK/Ork]'

and, for each effective asset demand function, we assume that own rate partials are positive, cross-rate partials are negative and partials with respect to f~, ~ are zero (both Lh and Lk are in excess demand). It follows that [Ja[ (the determinant of d3) is positive. From (A.31), (A.32) it follows that if H is relatively closer to L~, and K relatively closer to L~,, i.e., if

OH/OLin > OH~OLd,,

(A.33)

OK/OLI > OK/OLd,

(A.34)

and

then OH"/O~ < 0 and OK"/Oi~ > O. Solving for drh/d?~, drk/d? ~ we obtain drh

"df~ =

[ 0H"0K aK"a ]/ O?~ Ork ~--Oe~

Is31,

(A.35)

L.E. Molho, Loan rates as selective credit control

d~ =L 0~'~Orb t--~-~-IJ3]. drk

F

OK"OH

97

(A.36)

If (A.33), (A.34) hold then

drdd~ > 0 ~ d r d d e ~ > 0, and dG/df k < O=~drk/dfk < O.

Changes in ~k cannot stimulate investment in H while discouraging investment in K. Moreover, if all/dr k

aH"/a~

all/Or h

OK/Or------~< - OK"/O~ < - OK~Orh '

(A.37)

then drk/d?k
and

dr/fk>0.

(A.38)

Thus, if (A.37) holds, raising ~ will have the perverse effect of stimulating investment in K and discouraging investment in H. Note that if currency and deposits are equally close to L] and L~,, i.e., if OC/OL~h= OC/OL~k and

dD/OL~h= OD/OL~,,

(A.39)

then OC"/O~ =OD"/O~ =0.

(h.40)

The wealth constraint now holds for the effective rather than the notional asset demand functions and we have H" + K" +C" + D " = H o + Ko +Co + L.

(A.41)

Eqs. (A.40) and (A.41) imply OH"lOf~ = --OK"/Of~,

(A.42)

which guarantees that (A.37) holds. References Bank of Greece, Monthly statistical bulletin, various issues. Bitros, George, 1981, The fungibility factor in credit and the efficacy question of selective controls, Oxford Economic Papers, Nov.

98

L.E. Molho, Loan rates as selective credit control

Brainard, William and James Tobin, 1968, Pitfalls in financial model building, American Economic Review, May. Reprinted in J. Tobin, ed., 1971, Essays in economics, Vol. 1, Macroeconomics (North-Holland, Amsterdam). Cotula, Franco and Tommaso Padoa-Schioppa, 1971, Direct credit controls as a monetary tool, Quarterly Review, Sept. (Banco Nazionale del Lavoro). Dorrance, Graeme S., 1965, The instruments of monetary policy in countries without highly developed capital markets, Staff papers, July (International Monetary Fund, Washington,

DC). Foley, Duncan, 1975, On two specifications of asset equilibrium in macroeconomic models, Journal of Political Economy 83, no. 2. Halikias, D.H., 1978, Money and credit in a developing economy: The Greek case (New York University Press, New York). Kaminow Ira James M. O'Brien, eds., 1975, Studies in selective credit policies (Federal Reserve Bank of Philadelphia, Philadelphia, PA). Park, Yung Chul, 1973, The role of money in stabilization policy in developing countries, Staff papers, July (International Monetary Fund, Washington, DC). Patinkin, Don, 1958, Liquidity preference and loanable funds: Stock and flow analysis, Economica, Nov. Penner, R.G. and William Silber, 1973, The interaction between federal credit programs and the impact on the allocation of credit, American Economic Review 63, no. 5. Psilos, Diomedes, 1964, Capital market in Greece (Center of Economic Research, Athens). Rao, D.C. and Ira Kaminow, 1973, Selective credit controls and the real investment mix: A general equilibrium approach, Journal of Finance, no. 5. Silber, William, 1973, Selective credit policies: A survey, Quarterly Review (Banco Nazionale del Lavoro) no. 107. Tobin, James, 1969, A general equilibrium approach to monetary theory, Journal of Money, Credit and Banking, Feb. Tobin, James and William Brainard, 1963, Financial intermediaries and the effectiveness of monetary controls, American Economic Review 53. Zetrides, A., 1973, The banking system of Greece (Athens) (in Greek).