The Role of Banks in the
Transmission of Monetary Policy
Joe Peek and Eric Rosengren
Federal Reserve Bank of Boston*
FRB-Atlanta 2015 Financial Markets Conference:
Central Banking in the Shadows: Monetary Policy and
Financial Stability Postcrisis
Stone Mountain, GA
March 31, 2015
*The views expressed are my own and do not necessarily reflect those of the
Federal Reserve Bank of Boston or the Federal Reserve System.
Monetary Policy Transmission
• Noncontroversial: The interest rate channel of
the transmission of monetary policy
• More controversial: Is the interest rate
channel augmented, and if so, precisely how?
• Two primary mechanisms that have received
substantial attention:
– The broad credit channel
– The bank lending channel
The Credibility of Credit Channels
• Over time, we have observed an increased
emphasis on the asset side of bank balance
sheets
• The broad credit channel has achieved
widespread acceptance
• However, the narrower bank lending channel
has remained somewhat controversial
Haters Gonna Hate
• Even so, skepticism about the bank lending channel has
eroded through time
• Increasing recognition of the importance of bank loan
supply
– Chairman Greenspan’s references to “headwinds” to
monetary policy, an indirect reference to credit availability
problems
– Concerns about a bank “capital crunch” in the U.S. in the early
1990s
– Many policies implemented during the financial crisis were
intended to alleviate credit crunches:
• TARP
• The initial stress test that required raising capital ratios through
increased capital, not shrinking assets
• Lending facilities designed to mitigate a possible bank credit
crunch
– Basel III capital conservation buffer
Traditional Interest Rate Channel
• Focuses on the liability side of bank balance sheets
• To tighten monetary policy, open market operations
raise the federal funds rate and shrink reserves in the
banking system
• If the reserve requirement is binding, banks must
shrink reservable (transactions) deposits
• Banks raise interest rates on non-transactions deposits
to replace lost transactions deposits
• Interest rates on non-deposit alternatives also rise, and
increases in short-term rates are transmitted to longerterm interest rates
• Aggregate demand declines
• Note: Today, this traditional story is complicated by the
large volume of excess reserves in the banking system.
Broad Credit Channel
• Also known as the balance sheet effect or the financial
accelerator
• Based on credit market frictions associated with
asymmetric information and moral hazard that make
external finance an imperfect substitute for a firm’s internal
funds
• Does not require a distinction among alternative sources of
credit
• A tightening of monetary policy increases interest rates,
causing a deterioration in firm health in terms of both net
income (higher interest expenses, lower revenues) and net
worth (capitalizing lower cash flows with a higher interest
rate)
• Causes an increase in the external finance premium, raising
the cost of external funds by more than the increase in the
risk-free interest rate, further reducing aggregate demand
• Thus augmenting the interest rate channel
Bank Lending Channel
• Focus shifts from the liability side of bank balance
sheets to the asset side
• Tightening of monetary policy forces banks to
shrink reservable deposits
• Banks must either replace those deposits with
non-reservable liabilities or shrink assets (loans
and securities), or some combination
• To the extent that banks are unwilling or unable
to fully insulate their loan portfolio, the reduction
in loan supply augments the decline in aggregate
demand emanating from the increase in interest
rates
Distinguishing Between Credit Channels
• Does the source of credit matter?
• Do firms (borrowers) consider credit market
instruments and non-bank intermediated loans as
perfect substitutes for bank loans?
– Not all firms have access to public credit markets (for
example, smaller, more opaque firms)
– Nonbank intermediaries tend to focus on certain
types of loans, for example:
• Insurance companies: commercial real estate loans
• Finance companies: asset-backed financing
– Thus, clientele effects in bank lending result in many
firms being bank dependent, with few alternatives to
banks should their bank credit be curtailed
Challenges in Establishing the Bank
Lending Channel
• Must establish that a change in monetary policy
affects bank lending
– Banks do not fully insulate their loan portfolios by
adjusting other components of their balance sheets
– Identifying a bank-loan supply shift, given that a
decline in bank loans following a tightening of
monetary policy may simply reflect a decline in loan
demand due to weakened aggregate demand
• Then, if bank lending is affected, must establish
that a shift in bank loan supply affects aggregate
demand
Identifying a Shift in Loan Supply
• Complicated because banks face two separate
constraints: reserve requirements and capital
requirements
– Tightening a nonbinding constraint: now, for example,
open market operations to reduce excess reserves
– Easing a binding constraint: pushing on a string (implying
weaker effects from easing monetary policy than from
tightening policy)
– Banks face additional constraints: for example, the new
liquidity requirements
• Severe endogeneity issues associated with using
aggregate data
• Thus, empirical studies turned to panel data
analysis
Panel Analysis
• Relate cross-sectional differences in bank, or
banking organization, characteristics to
differences in the extent to which banks are able
to insulate their loan portfolios
– Ability to raise non-reservable (mostly uninsured)
liabilities: size, health, direct access to capital markets
– Extent to which the capital requirement constraint is
binding
– Liquidity position of bank
• Evidence: smaller, less healthy, and less liquid
banks, and non-publicly traded banks without
direct access to capital markets respond more to
a tightening of monetary policy
Effect Weakening Over Time
• Growth in loan securitization: increases bank
balance sheet liquidity
• Increased globalization of banking: can use
cross-border internal capital markets to
insulate against domestic liquidity shocks
• Diminished value of lending relationships with
the continued development of financial
markets, increased information availability
about borrowers, and expansion of shadow
banking
Real Effects of Loan Supply Shift
• Even if some banks cut back loan supply, other
banks or nonbanks may meet that unsatisfied
loan demand, and some firms will turn to market
finance (bonds, CP)
• Identify exogenous loan supply shock that avoids
the endogeneity problems (e.g., Japan banking
crisis for Japanese bank lending in U.S.)
• Focus on degree of bank dependence; differences
across geographic locations; differences across
GDP components in their reliance on bank credit
It’s Not Just Us
• We might expect the bank lending channel to be
even stronger in countries that are deemed to
have “bank-based” rather than “market-based”
economies
• Substantial evidence of loan supply effects from
banks experiencing deteriorated health in Japan
and other Asian countries, Europe, and Latin
America
• Bank characteristics matter, much as in the U.S.,
with the lending channel being stronger for banks
in poor health and/or suffering from liquidity
constraints
• The dramatic increase in securitization in Europe
has weakened the bank lending channel
Observations From Recent Events
• The financial crisis and its aftermath have reemphasized the important role of financial
intermediaries in the transmission of monetary
policy
• Our recent experience makes clear that most
large macroeconomic models failed to capture
the critical role of financial intermediaries in the
dynamics of the financial crisis
• Our experience with the zero lower bound makes
an operational bank lending channel even more
important for expansionary monetary policy to be
effective
Observations: Liquidity
• We need to increase our focus on the role of bank
liquidity management
• We need to pay more attention to securitized lending
– In contrast to our priors, it turned out to be a particularly
unstable source of financing during the crisis
– The drying up of the securitization pipeline put pressure
on bank liquidity, impaired new lending, and contributed
to fire sales of assets
– Increased haircuts on repos put additional stress on highly
levered financial intermediaries
• Increased reliance on wholesale funding compounded
funding pressure on financial intermediaries
– Given the regulatory response, the strength of the bank
lending channel will depend on how bank funding models
evolve
Observations: Changed Environment
• As a consequence of the large-scale asset
purchases, reserve requirements are no longer a
binding constraint for the banking system
• Bank lending behavior will likely be governed by
capital requirements and the effect of interest
rates on banks’ cost of funds and the profitability
of lending
• Recent studies have emphasized a risk-taking
channel of monetary policy transmission whereby
changes in risk appetite, partly a function of
monetary policy, generate a critical link between
monetary policy changes, the actions of financial
intermediaries, and the impact on the real
economy
Final Thoughts
• The empirical evidence provides substantial support for
the view that capital-constrained and/or liquidityconstrained banks and bank-dependent borrowers can
be adversely impacted by a tightening of monetary
policy
• The bank lending channel is important in an
international context
• Given our recent experiences, we now have a better
appreciation of the importance of financial
intermediaries, shadow banks as well as banks
• The next step is to develop a better appreciation for
those economists who do research on the critical role
of financial intermediaries in monetary policy
transmission, financial crises, and the macroeconomy
generally.