Credit guidance

Pioneered by the Reichsbank in 1912, credit guidance is a technique used at one stage by most central banks to manipulate bank credit creation in order to achieve monetary policy and sometimes industrial policy outcomes. This technique was transferred from Europe to Asia by Hisato Ichimada, who trained with Reichsbank president Hjalmar Schacht in the 1920s in Berlin, before later becoming the governor of the Bank of Japan, which used that instrument continuously from 1942 until at least 1991 (Werner, 2002, 2003a).

The common name for “credit guidance” in East Asia is “window guidance”. In this procedure, the central bank determines quarterly loan growth quotas for all banks in a top-down process starting with the desired nominal GDP growth, followed by the cor- responding growth in bank credit for GDP transactions (in accordance with the quantity theory of credit), which is then awarded pro rata to individual banks according to their assets size. Progress with the implementation of the loan quota is reported by the banks to the central bank on a monthly basis. During the monthly hearings, all information on bank balance re-allocate existing purchasing power. That, however, is a private sector activity whose regulation is difficult to justify. Not so for bank credit creation, which exploits the public privilege of issuing money for new transactions. As a result, a conflict of interest exists in the case of for-profit banks maximizing their shareholders’ value: their activities may be harmful for society or at least not “socially useful”. In this case, regulation, such as in the form of credit guidance, is justified.

Sometimes the examples of Japan during the 1980s and Thailand during the 1990s are cited as evidence that credit guidance policies are not effective. However, Werner (2002, 2003a, 2005) has shown that in both cases the credit guidance mechanism worked very effectively. The problem was that the central banks of these countries chose to set very high loan growth quotas and encouraged banks to provide unsustainable financial credit for speculative purposes. What is often neglected in this context is that credit guidance is not confined to periods when the central bank wishes to restrict bank credit. It can be and has been used as an effective tool to increase bank credit. This is possible, because the credit market is rationed and supply-determined, allowing banks to increase credit supply at any time (although at varying levels of risk, which is endogenous to the type and quantity of credit supplied). Therefore credit guidance can also be a useful tool to reduce unemployment during severe economic slumps, such as that in Spain or Greece since the euro-area crisis. It can be a part of a policy package to engage in credit easing.sheets, in particular their assets side, is disclosed.

The central bank frequently uses these procedures to enforce qualitative credit guid- ance, which can take the form of positive or negative credit guidance, or a combination thereof. In negative credit guidance, which is more frequent, banks are told by the central bank which industrial sectors and/or transactions should not receive credit from the banks. Frequently, unproductive credit creation is restricted; that is, bank loan extension for transactions that either do not contribute to GDP (credit for financial transactions, tending to result in asset price inflation and banking sector instability) or do not result in the production of goods and services or the implementation of new technologies (consumption credit, tending to result in consumer price inflation). This usage of credit guidance is in accordance with the quantity theory of credit.

Werner (2003b) contends that bank-centred financial systems were designed to enhance credit guidance. Banks were not supposed to undershoot or overshoot the credit quota. Compliance was ensured by punitive loan quotas in the following period or other measures costly to banks. Note that such compliance can be enforced by central banks, as banks are sooner or later virtually dependent on the cooperation of the central bank in the interbank market, and hence eager to maintain a close relationship.

The Japanese “window guidance” system was introduced in Korea and Taiwan when these were still part of Japan (until 1945), but maintained virtually unchanged in the post-war era. China introduced credit guidance as part of the reforms spearheaded by Deng Xiao Ping in the late 1970s and early 1980s, following his visits to Japan. Other countries using this tool at one stage include Thailand, Malaysia, and India. In Europe, credit guidance has been used by the central banks of the United Kingdom, France, Germany, Austria, Sweden, and Greece, among others. The US Federal Reserve used the tool sporadically, including in the 1920s. In post-war Germany credit guidance was not used, as the same outcome of ensuring productive use of credit could be achieved through a banking sector structure dominated by small, local, not-for-profit banks extending investment credit to small and medium-sized enterprises. During the early 1970s, a secret meeting at the Bank for International Settlements compared central bank experience concerning credit guidance, and recommended that central banks at least in public de-emphasize this tool, as it was not considered in accordance with the official theory of free markets (Werner, 2003a).

The degree of success of credit guidance is disputed. Some authors assert that the tool could not possibly be successful, as only banks are controlled by it, thus resulting in regulatory arbitrage as non-banks evade the procedure. However, this argument assumes that banks are merely financial intermediaries. In fact, banks are special, as they issue money through their extension of bank credit. That is precisely why it is sensible for central banks to monitor and guide bank credit. Non-bank financial intermediaries or capital markets for that matter do not need to be monitored in this way, as they can only re-allocate existing purchasing power. That, however, is a private sector activity whose regulation is difficult to justify. Not so for bank credit creation, which exploits the public privilege of issuing money for new transactions. As a result, a conflict of interest exists in the case of for-profit banks maximizing their shareholders’ value: their activities may be harmful for society or at least not “socially useful”. In this case, regulation, such as in the form of credit guidance, is justified.

Sometimes the examples of Japan during the 1980s and Thailand during the 1990s are cited as evidence that credit guidance policies are not effective. However, Werner (2002, 2003a, 2005) has shown that in both cases the credit guidance mechanism worked very effectively. The problem was that the central banks of these countries chose to set very high loan growth quotas and encouraged banks to provide unsustainable financial credit for speculative purposes. What is often neglected in this context is that credit guidance is not confined to periods when the central bank wishes to restrict bank credit. It can be and has been used as an effective tool to increase bank credit. This is possible, because the credit market is rationed and supply-determined, allowing banks to increase credit supply at any time (although at varying levels of risk, which is endogenous to the type and quantity of credit supplied). Therefore credit guidance can also be a useful tool to reduce unemployment during severe economic slumps, such as that in Spain or Greece since the euro-area crisis. It can be a part of a policy package to engage in credit easing.

See also:

Credit creation; Credit easing; Quantity theory of credit; Reichsbank; Schacht, Hjalmar Horace Greeley.