7/28/2019 The Credit Channel is an Enhancement Mechanism for Traditional Monetary Policy

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The credit channel is an enhancement mechanism for traditional monetary policy transmission, not a truly i ndependent or parallel channel. Discuss.

From a theoretical point of view, the credit channel composed of the bank lending

channel and the balance sheet channel could be completely incorporated in thetraditional monetary policy transmission if we operated in a world with no asymmetricinformation, moral hazard, differential taxation, agency, search and transactions costs,and if borrowers had homogenous preferences over internal and external sources of funding.

However, as soon as we relax these implausible assumptions, the credit channel canbecome a truly independent or parallel channel.

Some borrowers, such as small firms or consumers, are likely to be unable to raisefunds on the equity market or through bond issuing. This might occur because they areunable to signal their repayment characteristics, or because individual lenders may bewilling to lend long term funds only at a prohibitively high default risk premium. Banks,having a comparative advantage in terms of monitoring, transaction costs, and theability to match lenders and borrowers, will play a crucial role in this setting.

Loans become an imperfect substitute for other forms of finance, and any monetaryshock that significantly decreases the supply of loans, will affect the cost of finance forthe loans- dependent borrowers by more than the traditional monetary (increase ininterest rate) mechanism would imply.

Consider a monetary policy tightening, implemented through open-market sales, that raises the real interest rate. Bank reserves decrease, i.e. there is a shock to banks

balance sheets. The bank lending channel implies that there will be a change in the cost and availability of bank loans. Banks may increase the bank lending rate by more thanthe increase in the interest rate, or they can impose tighter collateral requirements inorder to ration lending. In both cases the change in the real interest rate is no longer avalid indicator of the change in financing costs for the loans- dependent agents. A credit crunch results as these agents start competing for the fewer available funds.Investment decreases by more than the traditional transmission mechanism wouldsuggest and there is a larger decrease in aggregate output.

Nevertheless, in this setting, one can still argue that the credit channel is simply anenhancement mechanism for the traditi onal transmission. Freixas and Rochet (1997)have even argued that this channel is insignificant because banks could simply maintaintheir loans supplies using instruments that have not been affected by the monetarypolicy tightening, such as certificates of deposits, commercial papers and long-term debt.Kashyap and Stein (1993) pointed out that if the share of loans provided by banks issmall relative to loans provided by other financial intermediaries, there will be marginlenders that will supply fund s as bank lending decreases.

However the recent crisis has demonstr ated that the credit channel is not a mereenhancement mechanism, but a truly independent and parallel channel.Financial innovation and securitization have led to a significant change in banks funding

types, which has a significant bearing on their ability to withstand balance sheet shocks.An increase in the real interest rate can lead to a decrease in bank equity prices,

7/28/2019 The Credit Channel is an Enhancement Mechanism for Traditional Monetary Policy

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lowering bank capital and implying a capital crunch . Banks with more profitable, but more volatile and non-interest income activities will suffer larger losses and respond bycontracting their lending by more. (Gambacorta, Marques-Ibanez, 2011 )

Furthermore, the bank lending channel enables us to analyse the interactions

between financial stability and monetary considerations which are also part of themonetary policy but cannot be accounted for by the traditional transmissionmechanism.

Stronger prudential regulation, such as increased minimum equity and core capitalrequirements under Basel III, affect bank loans supply not only in the present, but also inthe future by modifying banks risk taking incentives and funding structures.

There can also be a shift in banks willingness (not capacity) to supply loans, if banksfor e.g. perceive more risk and decide that they need to hold more liquidity.

The balance sheet channel is another component of the credit channel whichmakes it truly independent. It can be analysed using the Bernanke, Gertler, Gilchrist (1999) model in which lenders charge a premium equal to the expected value of monitoring costs. The latter will depend on the financial position of the borrower, whichwill itself be modified by monetary policy.

A monetary tightening resulting in a higher interest rate decreases output, lowersfirms asset prices, their Tobins q and their cash flows. The proportion of external tointernal funds in the financing of their projects increases. This acts as an adverse signalto lenders because firms have now lower stakes and are therefore more likely to default.The risk premium rises, further dampening investment and output.