It is widely believed that banks played a central role in the Great Recession, but where is the smoking gun? This column presents evidence from the UK confirming the conventional wisdom. It finds that banks transmitted the unprecedented external funding shock by cutting back on domestic lending.
How did problems originating in one asset class in one country propagate internationally, sparking the Great Recession? A standard stylised explanation relies on the globalisation of the banking system, and has two parts.
- First, stress in the US banking system (and others directly exposed to US mortgages and structured products) spread globally through international funding markets.
- Second, this shock to the foreign funding of various countries’ banking systems was transmitted domestically through a reduction in credit supply. While there is a substantial empirical literature documenting the first step above (Gorton and Metrick 2009, Eichengreen et al. 2009), evidence on the second step is rather slim. This may be because of the identification problem that arises when weak bank credit is observed jointly with weak domestic demand.