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5  The credit channel

The credit channel literature examines the impact of asymmetric information and other credit market frictions on real spending and economic activity, with resulting implications for monetary policy.[24] The bank lending channel analyses the impact of monetary policy on the supply of loans by depository institutions, and the balance sheet (or financial accelerator) effect focuses on the potential impact of monetary policy on firms’ balance sheets and their ability to borrow. The credit channel also operates when shifts in monetary policy alter either the efficiency of financial markets in matching borrowers and lenders or the extent to which borrowers face rationing in credit markets. With credit rationing, monetary policy may have real effects without changing interest rates in lending markets.

Monetary policy can have an impact on the supply of intermediated credit, which in most countries is predominantly provided by banks. A bank is a financial intermediary that participates in the payment system and finances entities in financial deficit, generally the public sector, firms and some households, using the funds of entities in financial surplus, typically households.

The reliance on bank credit is probably declining overall as corporations and, in particular, large businesses turn to the securities markets to meet their funding needs. However, an important fraction of firms, mainly small firms, are likely to remain bank-dependent at least in the near future (Trautwein, 2000). Moreover, banks are a critical source of liquidity even for large firms during times of economic stress (Saidenberg and Strahan, 1999).

The asset side of banks’ balance sheets consists of loans to the public sector, firms and households. The liability side includes deposits by households and firms plus banks’ equity. Banks’ equity consists of stock issues and retained earnings. Banks typically “borrow short” and “lend long”: they take deposits that can be withdrawn on demand or in a matter of months and make loans that often are only re-paid over periods of years. As a result, banks’ assets tend to have longer maturity than their liabilities. Monetary policy can have an impact on banks’ balance sheets because of this maturity mismatch of assets and liabilities. In the absence of perfect interest rate hedging, a tightening in monetary policy, i.e. an increase in interest rates, tends to cause a larger decline in the present value of the assets with longer maturity than the liabilities with shorter maturity. Conversely, a decline in interest rates causes a larger gain in the present value of the assets than the liabilities. For example, the decline in the market price of a unit future cash flow (see equation 2) due to an increase in is a function of , the number of years to maturity

(3)    

By construction, because the asset side of a balance sheet equals the liability side, a tightening in monetary policy that leads to a larger decline in the value of loans than the value of deposits, implies a contraction in banks’ value of equity. If banks are required by regulators or depositors to retain some minimum capital ratio (defined as the value of banks’ equity as a percent of the value of loans outstanding), they will have to either reduce their supply of loanable funds or raise new equity. However, because equity takes time to raise and also because the cost of new capital has increased due to higher interest rates and a lower market value of banks, the typical initial response is a contraction in lending.[25]

A reduction in the supply of bank loans increases the financing cost, or reduces the financing, of firms that are dependent on banks for credit. Bank-dependent firms are typically smaller in size (Gertler and Gilchrist, 1994). These firms tend to be bank-dependent because their access to (non-bank) capital markets is poor, because of reduced economies of scale with respect to intermediaries acquiring information about small firms. Moreover, the spread between the interest rate on loans paid by bank-dependent (small) firms and the interest rate paid by (large) firms, who use public debt markets, tends to increase during monetary contractions (Kashyap, Stein and Wilcox, 1993).

A reduction in the supply of bank credit reduces real activity. During the Asian crisis in the second half of the 1990s, for example, the disruption in the supply of credit was a major factor in the recessions experienced by the affected countries. Banks in these countries were unable or unwilling to establish credit facilities required for importers to provide overseas suppliers assurance of payment. The duration of a credit squeeze depends on how long it takes to establish new or revive old channels of credit after a disruption. In Asia it lasted several months in some countries and over two years in the case of Indonesia (Grimes, 1998).

The bank lending channel is likely to be more important in small open economies than large closed countries. This is because the proportion of small, typically bank-dependent, firms tends to be higher than in larger economies. Financial innovations and deregulation are unlikely to have materially improved bank-dependent firms’ ability to borrow from the capital markets. In the presence of open capital markets the information problem is augmented by additional informational asymmetries between foreign and domestic borrowers and lenders. Foreign investors may be less willing to lend to small firms than domestic lenders.

If banks are special in providing credit to a large fraction of firms in the economy, the amount of credit channelled through the banking system may have significant macroeconomic effects. Most macroeconomic models currently used by policy makers do not explicitly incorporate a banking sector and hence do not capture these bank lending effects of the monetary transmission mechanism.

Information asymmetries and the inability of lenders to monitor borrowers costlessly lead to “agency costs”, which create a wedge between the costs of internal and external financing for a firm (Bernanke and Gertler, 1989). Cash flow and net worth are important determinants of agency costs and hence the cost and availability of finance, and ultimately the level of investment (Walsh, 1998). For instance, a firm with high net worth (equity) thereby signals its credit-worthiness to banks which can in turn lend to the firm without having to incur the same expected monitoring costs, so lowering the cost of borrowing for the firm. If net worth is depleted, the result is a rise in the firm’s borrowing costs.

The second channel, the balance sheet or financial accelerator effect, focuses on the potential impact of monetary policy on firms’ financial positions and arises from the presence of agency costs. Agency costs in credit markets occur whenever lenders delegate control over resources to borrowers, leading to adverse selection, moral hazard and monitoring costs because of the inability to monitor borrowers or share in borrowers’ information costlessly.

As discussed in section 2, a tightening in monetary policy that raises real interest rates reduces the profitability of firms’ investment projects because of higher financing costs (and indirectly because of the prospect of a slowdown in consumption).[26] Higher interest expenses lower firms’ cash flow and internal funds, and could increase firms’ short-term borrowing (and interest expenses) if firms need to borrow to finance an inventory build-up as a result of slowing demand. Interest expenses may thus remain high for some time even after short-term interest rates have started coming down because of the rise in short-term debt outstanding.

The effects of a corporate cash squeeze on real activity depend largely on firms’ ability to smooth the decline in cash flows by borrowing. Gertler and Gilchrist (1994) find that larger firms, which are more likely to have recourse to commercial paper markets and other sources of short-term credit, typically respond to an unanticipated decline in cash flows by increasing their short-term borrowing. These firms are, at least temporarily, able to maintain their level of production and employment during periods of rising interest rate costs and declining revenues. As a result, inventories of large firms tend to grow following a tightening of monetary policy. In contrast, small firms, which in most cases have more limited access to short-term credit, respond to the cash squeeze by decumulating inventories and cutting work hours and production.

In the presence of agency costs, the effects of a monetary tightening will be amplified further via the balance sheet or financial accelerator effect. This is because the deterioration in firms’ balance sheets due to lower cash flow and internal funds worsens the agency problem and so increases the costs of external financing. Adding to the higher cost of external financing is the fact that higher interest rates lower the market value (or net worth) of firms and hence lower the value of assets that firms can use as collateral. As a result, banks may be less willing to lend to firms because the reduction in collateral increases banks’ potential losses from adverse selection: owners will have a lower equity stake in their firms, which gives them more incentive to engage in risky investment projects. In some cases, the decline in collateral may lead to loans not being extended upon maturity or even being recalled, i.e. forms of credit rationing.

A tightening in monetary policy that increases the external financing premium (or wedge between the costs of internal and external funding) will have additional contractionary effects on investment, output and spending. Higher interest rates may have a much stronger contractionary impact on the economy if balance sheets are already weak, introducing the possibility that non-linearities in the impact of monetary policy may be important.[27]

Notes

  • [24]See Bernanke and Gertler (1995), Mishkin (1995) and Trautwein (2000) among others.
  • [25]Sofianos, Wachtel and Melnik (1990) and Bernanke and Blinder (1992) provide empirical evidence of the response of bank loans to fluctuations in interest rates.
  • [26]The rise in borrowers’ interest expenses is, of course, only a redistribution from borrowers to lenders. However, a redistribution between borrowers and lenders is not neutral if, for example, lenders and borrowers do not have access to the same investment and spending opportunities.
  • [27]Credit market frictions that affect firms should also be relevant to the borrowing and spending decisions made by households, particularly spending on costly durable items such as automobiles and houses. In Carroll’s (1997) buffer stock model of consumption, for example, balance sheet effects impact on consumers’ willingness to spend. If consumers expect a higher likelihood of finding themselves in financial distress, they would rather be holding fewer illiquid assets like consumer durables or housing and more liquid financial assets. As discussed by Bernanke and Gertler (1995), this channel is still comparatively under-developed in the literature.
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