Peter Wailes

Money & Banking

Michaelmas 2015
Tutor: Dr Jacinta Pires
Week 2 Essay
The Monetary Transmission Mechanism (MTM) is the process by which
an initial change in monetary policy (e.g. interest rates) channels its way
through to tighter credit conditions in the real economy for firms and
households. These complex systems of channels, through which the MTM
operates, builds upon and provides more insight than the traditional money
channel view (IS-LM model). Policymakers have power over short-term
interest rates, and adjust the rates to change the cost of capital. Thus,
spending on durable goods decreases (Bernanke and Gertler 1995). In recent
years, prominent economists have identified issues with this simple approach
to monetary policy. There has been much research looking at imperfect
information in credit markets. Does credit matter? This question is at the
core of research on the narrow lending channel (NLC) and the broad credit
channel (BCC). The following paragraphs will explore the NLC, BCC, and other
factors that are relevant in explaining the magnitude of monetary policy
decisions in regards to bank lending.
The narrow lending channel theorizes that monetary policy influences
the supply of loans available by banks (Bernanke 2007). As a result of
contractionary monetary policy bank reserves decline. In the 1960s and 70s
Regulation Q capped interest rates payable on deposits. This prohibited
banks from counterbalancing the drop in deposits by offering higher interest

rates (Bernanke 2007). Further, because banks had limited alternative

funding sources, banks had to offset a decline in reserves by lending less
(Walsh 2010). If borrowers do not have a near-cost substitute for bank
borrowing, then a decrease in the availability of bank lending will impact
aggregate spending (Walsh 2010). Because of information advantages that
banks have in providing credit to borrowers, small firms in particular have a
hard time obtaining funding and, thus, cut spending (Walsh 2010).
The NLC has come under scrutiny. For example, in 1990, Romer and
Romer wrote that banks can switch easily to alternative sources of funding.
Because of this they expressed doubt over the significance of the NLC. It is
true that in recent years required bank reserve ratios have broadly been
removed. Without a minimum bank reserve ratio, the alleviation of
Regulation Q, and the fact that capital markets are generally more liquid and
accessible to banks, the above described bank lending channel is perhaps no
longer relevant to most major economies (Bernanke 2007). Still, though, the
channel is useful in examining impacts of monetary policy. While many
sources of funding are available for banks, these sources of funding do not
cost the same. Non-deposit funding is more expensive than deposit funding.
This is due to credit risks associated with uninsured lending. The cost of the
funding for each individual bank will depend on balance sheet factors.
Essentially, the creditworthiness of the bank dictates the price the bank pays
for non-depository funding. (Adverse selection, moral hazard, and monitoring
costs all are relevant in a lender-borrower situation. These factors lead to

agency costs because lenders are unable to fully monitor the borrowers
actions (Walsh 2010). The external finance premium (EFP) is the additional
cost paid by a borrower for external funding from lenders compared to the
risk free rate.) Due to concern about bank credit quality, banks pay EFPs. The
EFPs that banks pay are essentially transferred to bank borrowers (Bernanke
2007). Thus, in todays powerhouse economies, the major impact of the NLC
is based on changes in the quality of bank balance sheets.
In a 2000 paper, Kashyap and Stein tested the bank lending channel
theory using cross-sectional U.S. commercial bank data from 1976 1993.
They found evidence that the impact of monetary policy on lending is
stronger for banks with less liquidity. This evidence is statistically significant
in the bottom 95% of banks (measured by liquid asset size) (Kashyap and
Stein 2000). As mentioned above, this implies that tight monetary policy
increases the EFP (wedge between internal and external financing) for most
banks. The largest 5%, known to be Too Big To Fail, are able to avoid
financial accelerator effects because they can still post necessary collateral
to keep their EFP where is was prior to the monetary shock.
The broad credit channel examines the likely impact of monetary policy
on borrowers financial statements (Bernanke and Gertler 1995). In
frictionless credit markets, a fall in the value of a borrowers assets or
collateral will not affect credit decisions. The presence of agency costs does
increase the premium borrowers pay for external financing (Kuttner and
Mosser 2002). The external finance premium (as described above) facing a

borrower depends on the borrowers financial positioning. The more collateral

and value a potential borrower has, the lower said borrowers external
financing premium will be. Loan terms the credit borrowers face change with
monetary policy, and, logically, so does the spending decisions of the
borrowers (Bernanke and Gertler 1995). Bernanke and Gertler wrote: procyclical movements in borrower balance sheets can amplify and propagate
business cycles, a phenomenon that has been referred to as the financial
accelerator. The increase in EFP is accompanied by a decrease in
borrowers ability to finance internally. This leads to an increase in demand
for external finance (Radia 2010). Thus, when bank credit becomes more
expensive, borrowers become more dependent on it being available.
In 1996, Bernanke, Gertler, and Gilchrist wrote of three implications of
the BCC. First, for borrowers, financing externally is more expensive than
financing internally. This costs differential is partially due to agency costs.
Second, the difference between internal and external financing costs for
borrowers has an inverse relationship with the borrowers net worth. This
makes sense a fall in a borrowers net worth, will raise the cost of financing.
Third, adverse shocks to net worth (monetary shocks) will reduce borrowers
accessibility to finance. This lowers production levels. According to the
above implications, smaller firms will have higher agency costs (lower net
worth). In 1994, both Gertler and Gilchrist found evidence that small firms do
behave differently from large firms over the business cycle. In particular,
they found that small firms are more sensitive to fluctuations in money. In

1996, Oliner and Rudebusch found significance evidence that, in response to

contractionary monetary policy, small firms are impacted in terms of cash
flow on investment increases.
Ben Bernanke, in his 2007 speech, proposes that it is useful to think of
the new bank lending channel as a financial accelerator operating on bank
balance sheets instead of borrower balance sheets (Bernanke 2007). Both
the bank lending channel and the broad lending channel involve EFP
increases due to a decrease in asset value and collateral. The EFP rises for
banks to borrow funds, and this, in turn, further amplifies the EFP for bank
borrowers.
Finally, Id like to discuss the Bank Capital Channel. According to this
theory, which draws upon the NLC, monetary policy affects lending by its
impacts on bank equity (Heuvel 2002). This channel incorporates risk-based
capital requirements, and the imperfect market for bank equity. Huevel
writes that the bank lending channel is likely to be weaker when 1) among
adequately capitalized banks, (the market value of) equity is at high levels or
2) the fraction of poorly or undercapitalized banks is largethese conditions
are somewhat contradictory illustrates the importance of taking into account
the distribution of equity across banks, not just the mean. Contractionary
monetary policy can reduce bank capital in many ways. For example, bank
profits can fall because of maturity mismatch on a banks books (Radia
2010). These decreases in bank capital lead to bank equity decreases. As
opposed to the NLC (effects bank liquidity), the bank capital channel can

lead to a change in the composition of the balance sheet through an effect

on bank solvency (Huevel 2002). This is an additional channel than amplifies
the effect of monetary policy. Banks will loan less to increase risk-based
capital.
It is evident that there are many channels through which the MTM
operates, or potentially operates. The credit channels are the most widely
discussed in literature. With an ever-changing market (e.g. the emergence of
non-bank lenders), and policy changes, measuring and theorizing about the
magnitude of different MTM channels is difficult. What is certain is that the
cost of loans to borrowers varies inversely on the borrowers financial
condition (creditworthiness). While the lines are blurring between the NLC
and the BCC, the inverse relationship between creditworthiness and cost of
loans will always be instrumental to understanding the MTM. If I were to
continue research on this topic, I would focus efforts on the emergence of
non-bank lenders, and the magnitude of EFP changes in the NLC and BCC. As
research on the MTM improves, so will policy, and thus the effectiveness of
the central bank.
References

Slides From Money and Banking Lectures 1 and 2, Oxford University, October
2015.
Walsh, C. (2003), Monetary Theory and Policy, MIT Press, Cambridge
MA and London, 2nd ed.

Radia, A. (2010). Credit Supply Effects In The Monetary Transmission

Mechanism: UK Evidence From a New Bank Level Dataset.

Bernanke, B. and Blinder, A. (1998). Credit, Money and Aggregate Demand,

American Economic Review, May, pp. 435-39.

Bernanke, B. and Gertler, M. (1995). Inside the Black Box: The Credit
Channel of Monetary Policy Transmission, Journal of Economic
Perspectives, 9, no. 4, pp. 27-48.

Kuttner, K. and Mosser, P. (2002). The Monetary Transmission Mechanism:

Some Answers and Further Questions, Federal Reserve Bank of New
York Economic Policy Review, May.

Van Den Heuvel, Skander (2002). Does Bank Capital Matter for Monetary
Transmission?, Federal Reserve Bank of New York Economic Review.

Kashyap, A. and Stein, J. (2000). What Do a Million Observations on Banks

Have to say about the Monetary Transmission Mechanism?, American
Economic Review, 90, no. 3, pp. 407-28.

Bernanke, b., Gertler, M., and Gilchrist, S. (1996). The Financial Accelerator
and the Flight to Quality, The Review of Economics and Statistics, 78,
no. 1, pp. 1-15.

Bernanke (2007). The Financial Accelerator and the Credit Channel, Speech.