Question

It was found that a shock to the financial health of banks that may be caused by a decline in the asset markets affects the real economy. The study found that banks with greater real estate exposure have to reduce lending. Why do you this is? Please discuss your answer.

Answer 1

Introduction:

The financial health of banks are the sole base on which an economy is being judged in monetary terms. The financial condition of banks are affected by several reasons. These can be Capital adequacy, Asset Management, Equity, Liquidity, Economic Policies, Growth rates etc. One of these highly influencing factors is Asset Market.

Now, the question arises, what these assets markets are.

Assest markets are the markets belongs to that group of markets where participants of this market engage themselves in buying and selling of financial assets. For example:stocks,gold, real estate etc. So the buying and selling of high liquidity goods is involved in Asset Markets.

As we have discussed before that these goods are highly liquid, thus can be treated more or less equal to cash. However, due to unexpected reasons like (COVID-19), the behaviour and preference of the buyers tend to change. They behave in an unpredictable manner.Thus, economists find it difficult to analyse the market situation and predict the value of goods at present and in future.

Any decline in Asset Market, will lead to reduced value of the money or goods which earlier used to have a higher value. Hence, we will see a the purchasing power of customers even falling every single day. This will lead to their reduced capacity to spend for other non financial assets. Hence, affecting the Real Economy.

This vicious circle involves banks too.With reduced spending capapcity of consumers there comes reduced saving capacity of them as well. Thus, banks will fall short of expected investments which would have been made if asset market wasn't affected badly.

Turning our eye towards asset market dealers. Bank plays an important role in that case as well. Almost all the liquid assets are dealt through banks. Fall in their demand due to reduced profits will inturn cause them to face heavy losses and shake the financial condition of the banks.

Now, the point comes, what can banks do to come out of this vicious circle and bring other participants out of this never ending scenario. There can be many policies that might work. But we can say that if banks start investing in real estate and try to bring their price and quantity near equilibrium price, the consumers will regain their purchasing power and will free to regulate the money they have in the economy. This will although lead to an initial investment by banks but will definitely save them from further losses which they might face if the asset market declines.

We cannot say that this is the only solution. However, this can prove out to be a helpful one.