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Unfreezing Credit

Are banks refusing to lend because they think borrowers are too risky, and thus that they won't be able to meet their obligations to their own creditors, or is the problem that they fear being short of funds when investment opportunities - buying up distressed banks' assets - get even better. If it's the latter, more intervention will be needed to prevent fire sales.

CHICAGO – Little political enthusiasm exists for further support to the banking sector. One reason is that banks that received money in the initial rescues do not seem to have increased their lending, without which monetary and fiscal stimulus are unlikely to be effective. For banks to start lending again, even more intervention may be needed.

To see why, we need to understand why banks are still so reluctant. One possibility is that they worry about borrowers’ credit risk, though this would have to be extremely high to justify the complete cessation of long-term lending. A second possibility is that banks worry about having enough resources to meet their own creditors’ demands if they lock up funds in long-term loans. But the many central bank lending facilities that have been opened around the world should assuage these concerns, especially for large and well-capitalized banks.

On the other hand, perhaps banks’ reluctance to lend reflects a fear of being short of funds if investment opportunities get even better. Citicorp CEO Vikram Pandit said as much when he indicated that it was cheaper to buy loans on the market than to make them. And buying may get cheaper still!

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