A model of bank lending in the global financial crisis and the case of Korea

This paper studies two interrelated banking sector issues in the context of the global financial crisis and its impact on Korea: (i) To what extent did state owned banks expand lending to offset declining credit as private sector bank balance sheets deteriorated? (ii) In the recent crisis, was bank lending constrained because of funding or liquidity factors? To address these issues, a framework of optimal bank lending is presented in which banks face adverse selection in a market for risky investment projects, pay regulatory costs, and borrow in wholesale and traditional funding markets. The model implications are tested on bank-level data with a focus on the global financial crisis. The results point to significant credit expansion by public sector banks in response to deteriorating international credit conditions. Estimates of private sector lending during the crisis suggest that, at best, the credit crunch was less profound than it could have been. Wholesale funding is not found to have been a major driver of deteriorating credit conditions in Korea, reflecting, at least in part, strong policy support from the authorities during the crisis.