The Limits to Credit Growth: Mitigation Policies and Macroprudential Regulations to Foster Macrofinancial Stability and Sustainable Debt

In this paper we study an economy with a high degree of financialization in which (nonfinancial) firms need loans from commercial banks to finance production, service debt, and make long-term investments. Along the business cycle, the economy follows a Minsky base cycle with firms traversing through the various stages of financial fragility, i.e. hedge, speculative and Ponzi finance (cf., Minsky, 1978, 1986, 1992). In the speculative financial stage cash flows are insufficient to finance the repayment of principle but sufficient for paying interest, so banks are willing to roll-over credits in order to prevent loan defaults. In the Ponzi financial position even interest payments cannot be served, but banks my still be willing to keep firms alive through ”extend and pretend” loans, also known as zombie-lending (Caballero et al., 2008). This lending behavior may cause credit bubbles with increasing leverage ratios. Empirical evidence suggests that recessions following such leveraging booms are more severe and can be associated to higher economic costs (Jordà et al., 2013; Schularick and Taylor, 2012). We study macroprudential regulations aimed at: (i) the prevention and mitigation of credit bubbles, (ii) ensuring macro-financial stability, and (iii) limiting the ability of banks to create unsustainable debt bubbles. Our results show that limiting the credit growth by using a non-risk-weighted capital ratio has slightly positive effects, while using loan eligibility criteria such as cutting off funding to all financially unsound firms (speculative and Ponzi) has strong positive effects.