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Information sharing, credit booms, and financial stability

11.10.2016F.Leon, University of Luxembourg & S. Guérineau, Université d'Auvergne

The global financial crisis has highlighted the vulnerability of financial systems and stressed the need for improving the management of financial vulnerability. The financial stability issue in low-income countries (LICs henceforth) has received less attention in recent years, insofar as they have been less impacted by the global financial crisis than emerging economies. However, a better understanding of financial fragility mechanisms in LICs is crucial. The experience of LICs shows that they could suffer sharp increases in non-performing loans and banking crises, and that the cost of banking crises is high, even if the banking sector is small.

In a recent paper, we investigate the determinants of financial fragility in advanced and developing countries, focusing on the interaction between credit booms and credit information sharing systems. A large number of studies have shown that excessive credit booms are one of the main drivers of financial crises. The development of credit information sharing (CIS) institutions may attenuate the negative effect of credit booms and/or limit the occurrence of such booms.

First, CIS can mitigate the negative effect of credit booms. A rapid growth of credits can weaken the quality of credit screening. During credit booms, credit officers cannot devote sufficient time to correctly screen new projects and bad projects have a higher probability of being financed. The presence of efficient CIS institutions could attenuate the negative effect of credit booms with screening. In addition, credit booms often fuel a rapid rise in asset prices (real estate and equity bubbles). Since assets may be used as collateral, the price rise will itself help an acceleration of credit growth ("financial accelerator") and reinforce the deterioration of screening. The presence of information sharing mechanisms may allow banks to diversify their portfolio. This diversification can limit the increase of asset prices induced by rapid credit growth, and therefore limit the detrimental impact of such episodes.

Second, CIS might affect the occurrence of credit booms, even if its effect is theoretically unknown. On the one hand, information sharing may curb credit growth by avoiding some customers borrowing from several banks. On the other hand, a reduction in the information asymmetries across banks may lead to an easing of lending standards and, in turn, an increase in the volume of lending (lending boom). Mechanisms through which CIS alleviates the detrimental and occurrence of credit booms can differ between developing countries and industrialized economies.

In order to identify the impact of information sharing and its transmission channel, we built a dataset combining a bank-level and country-level database. The sample included 159 countries with 79 developing countries and 80 emerging and developed countries over the period 2008-2014. To study whether developing countries differ from other countries, two groups of countries were distinguished: countries with a GNI per capita below US$ 4,125 in 2014 (n=79, called developing countries) and countries with a GNI per capita exceeding US$ 4,125 (n=80, called developed and emerging countries). Financial fragility was assessed by scrutinizing annual changes in the ratio of NPL to total loans. Episodes of financial fragility were identified every time this ratio jumped by at least 3%. This measure enabled capturing all episodes of financial distress and not only the extreme ones (banking crisis). The development of CIS was assessed by the depth index and the coverage of CIS. Both were extracted from Doing Business.

Estimations confirmed findings from other papers by highlighting the stabilizing impact of CIS. The paper also documented that this result held for both less developed countries (GNI per capita below US$ 4,125) and other countries (advanced and emerging). In a second step, the complex relationships between CIS, credit booms and financial fragility were analyzed. Econometric estimations pointed out several important results: (i) information sharing development had a direct effect on financial stability, even when the impact of credit booms was taken into account; (ii) the higher the scope of information collected, the lower the likelihood to observe a credit boom (but the coverage of CIS did not matter); this effect was smaller and less significant in developing countries; (iii) CIS mitigated the detrimental effect of credit boom but this result held only for advanced and emerging countries; and (iv) credit booms were strong predictors of financial vulnerability, especially in advanced and emerging countries.

These results have several policy implications. First, credit growth is a key variable for macro-prudential policies in low and middle income countries. Second, current efforts to develop CIS schemes should be strengthened, since the latter allow for credit expansion without excessive increase in the overall credit risk. Third, CIS has little impact on credit booms in developing countries, which justifies the extension of other tools - such as macro-prudential policies - to prevent excessive credit growth. Finally, extending the coverage of information sharing systems is not enough, since depth of information sharing is more efficient in avoiding credit booms.

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About the Authors

Florian Léon is currently a postdoctoral research fellow at CREA (University of Luxembourg). Samuel Guérineau is an Associate Professor at the Université d'Auvergne.

This work is part of a research project which received financial support from the DFID-ESRC Growth Research Programme (Grant No. ES/L012022/1). Other project's contributions focus on the implications of capital flows (FDI, aid, remittances) on long-term growth. All contributions are available and can be commented on the blog dedicated to the project.

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