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 longer- term 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 re- emphasized 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 liquidity- constrained 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.