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Should we blame toxic loans for a financial crisis?

  • Writer: Macroprudential Policy
    Macroprudential Policy
  • May 14, 2020
  • 3 min read

Updated: Aug 16

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In unequal economies, banks become vectors for toxic debt.

Monetary policy’s response to underconsumption—cheap credit—inflates leverage until mass defaults trigger crises.


Introduction


Banks exist to bridge the gap between savers and investors in an economy where these groups are typically distinct (Lulford, 2014). However, their role extends beyond mere intermediation—they also amplify systemic risks through debt creation, particularly when inequality distorts consumption patterns. Rising wealth concentration (Piketty, 2014) forces monetary policymakers to stimulate debt to sustain demand, creating a cycle of toxic loans that trigger crises when mass defaults occur. This essay examines banks’ traditional functions while highlighting how structural inequality transforms their role into a conduit for financial instability.


The Dual Role of Banks: Intermediation and Debt Creation


In unequal economies, banks also become tools to counteract underconsumption—a phenomenon where wealth concentrated in the top 1% suppresses demand among the bottom 99% (Stiglitz, 2012). To offset this, central banks lower interest rates, encouraging households to borrow rather than rely on stagnant wages (Kumhof et al., 2015). For example:

  • U.S. household debt rose from 65% of GDP in 2000 to 98% before the 2008 crisis (Federal Reserve, 2023).

  • In China, debt-to-GDP surged to 300% as inequality widened (World Bank, 2022).


This debt expansion fuels toxic loans, which banks distribute due to monetary incentives rather than recklessness.


Three Functions of Banks in a Fragile System


1. Liquidity Transformation: A Double-Edged Sword


Banks convert short-term deposits into long-term loans, enabling 24/7 access via ATMs (Armour, 1999). However, this relies on depositor confidence. During crises (e.g., the 2007 Northern Rock collapse), panic withdrawals expose systemic fragility (Shin, 2009).


2. Maturity Transformation: Fueling Debt Dependence


Banks fund 30-year mortgages with short-term deposits, supporting homeownership. But when inequality rises, households rely on debt to maintain consumption. In the U.S., the bottom 90%’s debt-to-income ratio hit 142% in 2008 (Saez & Zucman, 2014).


3. Risk Transformation: From Pawnshops to Securitization


Banks mitigate credit risk via diversification, yet securitization (e.g., subprime mortgage CDOs) concentrated risk before 2008 (Gorton, 2010). Post-crisis, nonbanks like shadow lenders replicated this with leveraged loans (FSB, 2023).


Systemic Risks Amplified by Inequality and Debt


Liquidity Risk: The Panic Amplifier


Bank runs (e.g., Silicon Valley Bank, 2023) emerge when depositors flee en masse. However, such panics are often preceded by debt saturation—when overleveraged borrowers default, banks’ asset quality collapses (Bernanke, 2018).


Credit Risk: Toxic Loans and Cascading Defaults


Rising inequality correlates with higher NPLs. In Spain, NPLs spiked to 13.6% post-2008 as unemployment hit 26% (ECB, 2014). Monetary easing post-crisis masked the problem but expanded private leverage to 165% of GDP in advanced economies (BIS, 2023).


Conclusion: Banks as Intermediaries and Crisis Catalysts


Banks enable growth by storing savings in investments, but in unequal economies, they become vectors for toxic debt. Monetary policy’s response to underconsumption—cheap credit—inflates leverage until mass defaults trigger crises (Mian & Sufi, 2014). Reforms must address inequality to break this cycle.


References


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