Question

In the period since the financial crisis of 2007-2009, inflation has been low in many countries, while a few experienced outright deflation. Why might unexpected deflation be of particular concern to someone managing a bank? Unexpected deflation is associated with ________ of borrowers, as the nominal value of their assets _______ but the dollar amount of their liabilities _______ . This weakens creditworthiness and can lead to ________ lending as asymmetric information problems worsen. In turn, ________ credit supply can diminish economic activity, leading to _________ defaults, a deterioration in the quality of the bank’s balance sheet and ultimately to bank insolvency.

Answer 1

Your sentence should read as follows:

Unexpected deflation is associated with falling net worth of borrowers, as the nominal value of their assets falls but the dollar amount of their liabilities remain the same . This weakens creditworthiness and can lead to reduced lending as asymmetric information problems worsen. In turn, reduced credit supply can diminish economic activity, leading to increased defaults, a deterioration in the quality of the bank’s balance sheet and ultimately to bank insolvency.

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When there is an unexpected deflation, the value of the assets held by the borrower decreases. However their liabilities do remain the same. Since the proportion of equity in asset declines, the position becomes more leveraged. Due to increase in leverage, flow of credit slows down. Because of this, firms are not able to access the sufficient and hence probability of defaults increases.