Loan Pushing
Loan Pushing
UNDERSTANDING THE 1982 DEBT CRISIS
One of the international social interactions that occurs between countries is lending by banks of one country (the creditor ) to individuals or the government of a different country (the debtor ). Loan pushing refers to the attempt of a creditor with market power to sell a higher volume of credit at a higher rate of interest to a debtor than the creditor would if it lacked market power. The creditor’s market power may stem from a low number of credit suppliers or from the formation of a consortium or syndicate of creditors, such as a consortium of four hundred international banks negotiating with a single country. Loan pulling, in contrast, is the effort of a debtor to gain more credit if it is not faced with loan pushing but rather with credit rationing, which means that the debtor does not get as much credit as it would like at a given interest rate. If the debtor has no market power, it will not get more credit than the rationing creditor wants to give it.
Jonathan Eaton and Mark Gersovitz (1981) show that many countries, but by far not all countries, are credit rationed. William Darity (1986), Barry Eichengreen (1989), and Kaushik Basu (1991) have collected anecdotal evidence for loan pushing. Articles by Thomas Ziesemer (1997) and Ashwini Deshpande (1999) describe loan pushing and related forms of excessive lending.
THEORY
A theoretical model for loan pushing is presented in Figure 1. Imagine that a bank consortium uniting all banks and thereby constituting a monopoly is the supplier of credit and a country is the debtor. The debtor would like to incur debt L for any given interest rate i as indicated by the curve DD ′. All combinations of interest, i, and credit volume, L, along the line DU 0 are considered to be as good as getting no credit. The monopolist creditor gets the amount of
money to be lent, L, from the world market at interest cost rL. The monopolist obtains interest revenue iL and assumes it will get the money back.
The monopolist now can choose between two types of behavior. It can either be customer friendly, offering a contract on the curve DD ′, or it can look at its profits and try to maximize them. In the latter case, the monopolist creditor will recognize that curves such as π′ (or πm ) represent combinations of interest rates and credit volumes that have equally large profits and therefore are called isoprofit lines. But a curve with higher interest and credit volume represents higher profits. The monopolist knows that the debtor will not accept a contract with interest and credit volume making the debtor worse off than getting no credit; the debtor therefore will reject offers represented by points to the upper right of DU 0. The highest profit the creditor can get is therefore a combination such as (Lm, im ). The monopolist can achieve this by telling the customer “either you take this or you get no credit at all.” This is called a take-it-or-leave-it offer. The debtor accepts because it is slightly better off with the contract than without it.
Of course, this scenario works only if there is no competitor offering a better contract to the debtor and only if the monopolist creditor really is a monopolist. Compared to a situation without monopoly power, where the debtor can get Lc at interest rate r, the interest rate is higher and the credit volume is larger, as stated in the definition of loan pushing above. Therefore, (Lm, im ) is also called the loan-pushing equilibrium, and (Lc, r ) is called the competitive equilibrium.
Now, eliminate the assumption that the creditor is sure to receive its money back with interest. Instead, the creditor may expect sovereign risk —a political problem caused by governments that wish to protect debtors who refuse to pay (repudiation)—and expect to get only some payment, which increases with the money lent, say b (L ). This scenario is illustrated in Figure 2. The creditor would want to make sure that it does not lend more than it can get back. If the creditor can impose a punishment b (L ) on the repudiating debtor, the creditor would prefer to limit the credit such that the punishment is as large as the money to be paid, b (L ) = (1 + i )L, or, i = b (L )/L-1. The profit (i -r ) L, after insertion of this constraint with equality is, b (L )-(1 + r )L. Its maximum now is where the b (L ) curve in Figure 2 has the maximum distance from the (1 + r ) L curve, at Lr. If the debtor wants less credit, there is no problem; but if the debtor wants more credit, it will not be offered and the debtor is called to be rationed at Lr.
UNDERSTANDING THE 1982 DEBT CRISIS
An essential feature of the debt crisis in the beginning of the 1980s was the sharp rise in the world market interest
rate r. If credit markets were competitive, as at the equilibrium (r, Lc) in Figure 1, the horizontal line would shift up and Lc would fall. Similarly, if the economy is and remains in a loan-pushing equilibrium, it moves along the reservation-utility line DU 0 to the upper left, resulting in (Lm ′, im ′) with higher interest rates im and a lower credit volume, as isoprofit lines can be shown to flatten for a higher world interest rate r and moving from π* to π*′.
If the country is and remains in the credit-rationing regime shown in Figure 2, the line (1 + r )L becomes steeper when r rises, and therefore the profit maximizing point moves to lower credit volumes. However, whereas the evidence described above indicated that there was loan pushing before the 1982 crisis, the evidence after the crisis was that the balance of trade in goods and services had shifted to positive values and credit was limited to ensure that interest could be paid. Basu (1991) suggested that this would indicate that there was a shift from loan pushing to credit rationing. Ziesemer (1997) showed that this is possible if, in terms of Figure 3: (1) the credit-rationing function, i = b (L )/L - 1, intersects with the DU 0-line; (2) the former is flatter than the latter; (3) the initial equilibrium is the loan-pushing equilibrium P ; and (4) the increase in the world market interest rate is large enough to come to a credit-rationing equilibrium R rather than to an equilibrium between P and the intersection point R. A flat function b (L )/L means that the punishment function must have a slope that is not decreasing too strongly with the credit volume L. The crucial point then is that, for some countries, credit rationing does not prevent crises but occurs upon an interest shock in order to avoid high losses from sovereign risk after the crisis, which was preceded by loan pushing.
BEYOND THE MODEL
Why is it profit-maximizing to push rather than to ration? There are several answers to this question. First, banks make the salaries of sales agents dependent on profits, (i - r ) L. Selling more and at higher interest rates maximizes agents’ salaries (Darity 1986).
Second, third parties, such as a firm selling machines to a debtor country paid by the credit money, L, and being a client of the bank(s), may play a role. For example, the client may be a current bad risk that the bank can get rid of by giving the credit, which is used to increase the revenue when the machines are sold. The bank may now substitute a current risk of the firm by a future risk from the debtor country. Or, more generally, the firm has higher revenue and deposits more money in the bank, thus enhancing expected bank profit. Deshpande (1999) extends the loan-pushing part of Basu’s (1991) model to include a third party and a more general cost function. Deshpande also provides anecdotal evidence and discusses the role of large and small banks in a syndicate.
Third, illegal activity may occur. For example, a bank manager may own shares of the firm, which increase in value if the firm can sell machines to the debtor country. A gain for the manager is exchanged for a risk for the bank. Fourth, economies of scale and scope of the bank may be valued higher than the new risk from the debtor country, especially if the latter is perceived to be low.
BIBLIOGRAPHY
Basu, Kaushik. 1991. The International Debt Problem, Credit Rationing, and Loan Pushing: Theory and Evidence. Princeton, NJ: Princeton University Press.
Darity, William, Jr. 1986. Did the Commercial Banks Push Loans on the LDCs? In World Debt Crisis: International Lending on Trial, ed. Michael P. Claudon, 199–225. Cambridge, MA: Ballinger.
Deshpande, Ashwini. 1999. Loan Pushing and Triadic Relations. Southern Economic Journal 65 (4): 914–926.
Eaton, Jonathan, and Mark Gersovitz. 1981. Debt With Potential Repudiation: Theoretical and Empirical Analysis. Review of Economic Studies 48 (2): 289–309.
Eichengreen, Barry. 1989. The U.S. Capital Market and Foreign Lending, 1920–1955. In Developing Country Debt and Economic Performance. Vol. 1: The International Financial System, ed. Jeffrey Sachs, 107–155. Chicago: University of Chicago Press.
Ziesemer, Thomas. 1997. From Loan Pushing to Credit Rationing: A Brief Note on Interest Shocks in a Model by Basu. Journal of Institutional and Theoretical Economics 153 (3): 569–578.
Thomas Ziesemer