Greece, Spain, Ireland, and even the United States have experienced banking crises with a common origin: the rapid growth of private sector credit provided by banks. So, what caused the high credit growth in these countries and can this high credit growth predict banking crises?

For the peripheral European countries – Greece, Ireland, Portugal and Spain in particular – a primary driving factor for credit expansion was the introduction of the Euro itself. This monetary integration process lead to interest rate convergence to the low-rate anchor countries such as Germany. By joining the Euro, investors became overoptimistic about the economic outlook for these peripheral countries. This pushed a credit explosion from both supply and demand sides – consumers demanded more credit as they expected their incomes to grow and could service the debt later, and banks wanted to increase lending.

As shown from the figure below, the pre-crisis growth of bank credit relative to GDP for many European countries was very high, particularly when compared to the long-run average of the same variable (1.4 percentage points per year), measured from 1973-2009 for roughly 80 countries.



In the United States, the credit surge was caused by continually increasing housing prices. Consumers (and lenders) assumed this increase would continue and the asset price would always appreciate. Historically low interest rates further fueled this surge. As demand for credit increased, lenders responded with subprime mortgages. As borrowers became unable to service the debt and home prices began declining, the subprime mortgage markets collapsed. The cause of the credit surge in the United States was therefore due to banks’ financing household consumption.

Financial openness and liberalization can also lead to surges of foreign inflows of capital. This foreign capital served as an additional resource to finance domestic lending, leading to a substantial growth of private credit to GDP. This was the case in Mexico in 1994 and in East and Southeast Asia in 1997-98. New policies lead to a growth of available private credit compared to the GDP. Some advanced economies (e.g. Spain, Ireland, the United Kingdom and the United States) also experienced similar patterns of capital inflows in the run up to 2008. In particular, Ireland’s bank borrowing from abroad grew around 40% (the average is about 9.4% for Europe) a year in four years prior to the crisis, as Irish banks began to draw on net cross-border financing to support their domestic lending. The result was the crash in 2008.

Not all rapid credit growth episodes lead to a crisis. In today’s financial system, credit is important in facilitating economic activity by helping households and firms obtain access to financing for their expenditures. Only credit growth episodes that are associated with distortions in economy end up in banking crises. These distortions include over-leveraging captured, large inflows of bank loans from abroad which could contribute to over-lending domestically, surges in asset prices reflecting widespread optimism and its eventual market correction, and weak bank regulation and supervision in monitoring and curtailing excessively and risky lending of banks.

These findings have important implications for macroprudential policy frameworks. Monitoring of these “distortion factors” along with credit growth could produce useful information about the probability of crisis and enable authorities to take appropriate action. Excessive credit growth is typically followed by a bust marked by a severe contraction of credit and subsequently an economic downturn resulting from collapsed investment and consumption expenditures as we all are experiencing today.



This blog is based on a larger paper “Are Certain Causes of Credit Growth More Harmful than Others? Evidence from Banking Crises in Europe”, co-authored with Puspa Amri, Ph.D. candidate from Claremont Graduate University and Clas Wihlborg, the Fletcher Jones Chair in International Business at Chapman University, and recently presented at the 14th Annual SNEE European Integration Conference in Sweden.