The credit channel at work - lessons from the Republic of Korea's financial crisis

The authors suggest that the credit channel - as a transmitter of monetary and financial shocks - appears to have aggravated the Republic of Korea's economic crisis. They use micro-data gathered at the bank level to better identify this channel of transmission. They find that: 1) Monetary tightening broadens the spread between marginal bank lending rates and corporate commercial paper rates (consistent with hypothesis that bank lending is a transmitter of monetary shocks). 2) Credit limits on overdrafts - arguably a proxy to identify shifts in the loan supply - react negatively to the monetary squeeze. 3) After the stiffening of bank capital adequacy requirements, banks suffering from larger negative capital shocks experience a more marked slowdown in lending and deposit-taking and also raise their loan rates disproportionately. These findings lend support to the hypothesis that autonomous contraction by banks restricts the availability of credit and magnifies the increase in its cost. This phenomenon compounded the Korean crisis by aggravating liquidity constraints for most agents that rely on bank credit as their only external source of funds. Policymakers may want to provide relief - possibly through market-based actions - to the small and medium-sized enterprises (and other businesses) that suffer unduly from such a credit crunch. To reduce obstacles to recovery, they may also want to devise market-based incentives to make bank loans available to healthy firms in sectors (such as exports) on which recovery depends.