The Role of B anks in the Transmission of Monetary Policy - PowerPoint Presentation

1. The Role of Banks in the Transmission of Monetary PolicyJoe Peek and Eric RosengrenFederal Reserve Bank of Boston*FRB-Atlanta 2015 Financial Markets Conference:Central Banking in the Shadows: Monetary Policy and Financial Stability PostcrisisStone Mountain, GAMarch 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.

2. Monetary Policy Transmission Noncontroversial: The interest rate channel of the transmission of monetary policyMore controversial: Is the interest rate channel augmented, and if so, precisely how?Two primary mechanisms that have received substantial attention:The broad credit channelThe bank lending channel

3. The Credibility of Credit ChannelsOver time, we have observed an increased emphasis on the asset side of bank balance sheetsThe broad credit channel has achieved widespread acceptanceHowever, the narrower bank lending channel has remained somewhat controversial

4. Haters Gonna HateEven so, skepticism about the bank lending channel has eroded through timeIncreasing recognition of the importance of bank loan supplyChairman Greenspan’s references to “headwinds” to monetary policy, an indirect reference to credit availability problemsConcerns about a bank “capital crunch” in the U.S. in the early 1990sMany 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 assetsLending facilities designed to mitigate a possible bank credit crunchBasel III capital conservation buffer

5. Traditional Interest Rate ChannelFocuses on the liability side of bank balance sheetsTo tighten monetary policy, open market operations raise the federal funds rate and shrink reserves in the banking systemIf the reserve requirement is binding, banks must shrink reservable (transactions) depositsBanks raise interest rates on non-transactions deposits to replace lost transactions depositsInterest rates on non-deposit alternatives also rise, and increases in short-term rates are transmitted to longer-term interest ratesAggregate demand declinesNote: Today, this traditional story is complicated by the large volume of excess reserves in the banking system.

6. Broad Credit ChannelAlso known as the balance sheet effect or the financial acceleratorBased on credit market frictions associated with asymmetric information and moral hazard that make external finance an imperfect substitute for a firm’s internal fundsDoes not require a distinction among alternative sources of creditA 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 demandThus augmenting the interest rate channel

7. Bank Lending ChannelFocus shifts from the liability side of bank balance sheets to the asset sideTightening of monetary policy forces banks to shrink reservable depositsBanks must either replace those deposits with non-reservable liabilities or shrink assets (loans and securities), or some combinationTo 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

8. Distinguishing Between Credit ChannelsDoes 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 loansFinance companies: asset-backed financingThus, clientele effects in bank lending result in many firms being bank dependent, with few alternatives to banks should their bank credit be curtailed

9. Challenges in Establishing the Bank Lending ChannelMust establish that a change in monetary policy affects bank lendingBanks do not fully insulate their loan portfolios by adjusting other components of their balance sheetsIdentifying 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 demandThen, if bank lending is affected, must establish that a shift in bank loan supply affects aggregate demand

10. Identifying a Shift in Loan SupplyComplicated because banks face two separate constraints: reserve requirements and capital requirementsTightening a nonbinding constraint: now, for example, open market operations to reduce excess reservesEasing 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 requirementsSevere endogeneity issues associated with using aggregate dataThus, empirical studies turned to panel data analysis

11. Panel AnalysisRelate cross-sectional differences in bank, or banking organization, characteristics to differences in the extent to which banks are able to insulate their loan portfoliosAbility to raise non-reservable (mostly uninsured) liabilities: size, health, direct access to capital marketsExtent to which the capital requirement constraint is bindingLiquidity position of bankEvidence: 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

12. Effect Weakening Over TimeGrowth in loan securitization: increases bank balance sheet liquidityIncreased globalization of banking: can use cross-border internal capital markets to insulate against domestic liquidity shocksDiminished value of lending relationships with the continued development of financial markets, increased information availability about borrowers, and expansion of shadow banking

13. Real Effects of Loan Supply ShiftEven 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

14. It’s Not Just UsWe might expect the bank lending channel to be even stronger in countries that are deemed to have “bank-based” rather than “market-based” economiesSubstantial evidence of loan supply effects from banks experiencing deteriorated health in Japan and other Asian countries, Europe, and Latin AmericaBank characteristics matter, much as in the U.S., with the lending channel being stronger for banks in poor health and/or suffering from liquidity constraintsThe dramatic increase in securitization in Europe has weakened the bank lending channel

15. Observations From Recent EventsThe financial crisis and its aftermath have re-emphasized the important role of financial intermediaries in the transmission of monetary policyOur recent experience makes clear that most large macroeconomic models failed to capture the critical role of financial intermediaries in the dynamics of the financial crisisOur experience with the zero lower bound makes an operational bank lending channel even more important for expansionary monetary policy to be effective

16. Observations: LiquidityWe need to increase our focus on the role of bank liquidity managementWe need to pay more attention to securitized lendingIn contrast to our priors, it turned out to be a particularly unstable source of financing during the crisisThe drying up of the securitization pipeline put pressure on bank liquidity, impaired new lending, and contributed to fire sales of assetsIncreased haircuts on repos put additional stress on highly levered financial intermediariesIncreased reliance on wholesale funding compounded funding pressure on financial intermediariesGiven the regulatory response, the strength of the bank lending channel will depend on how bank funding models evolve

17. Observations: Changed EnvironmentAs a consequence of the large-scale asset purchases, reserve requirements are no longer a binding constraint for the banking systemBank lending behavior will likely be governed by capital requirements and the effect of interest rates on banks’ cost of funds and the profitability of lendingRecent 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

18. Final ThoughtsThe empirical evidence provides substantial support for the view that capital-constrained and/or liquidity-constrained banks and bank-dependent borrowers can be adversely impacted by a tightening of monetary policyThe bank lending channel is important in an international contextGiven our recent experiences, we now have a better appreciation of the importance of financial intermediaries, shadow banks as well as banksThe 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.