7 Summary and conclusions
Macroeconomic models currently used by policy makers generally assume that the Modigliani and Miller (1958) theorem holds. The theorem implies that, under the assumptions of complete markets and the absence of information and transaction costs, the workings of financial markets can be fully summarised by financial prices and allows one to abstract from considerations of credit market conditions. However, imperfect information and theories of financial intermediation suggest that information and transactions costs are important and the assumptions upon which the Modigliani-Miller theorem is based, and thus macroeconomic models used by policy makers, do not hold in practice. These models hence disregard the importance of credit markets and financial intermediaries not only for individual depositors but the economy as a whole.
Financial intermediaries play an important role because they reduce the cost of channelling funds between relatively uninformed depositors to uses that are information-intensive and difficult to evaluate. If banks and other intermediaries provide credit to a large fraction of firms, who otherwise would not be able to borrow, the amount of credit channelled through the banking system can have significant macroeconomic effects, highlighting the importance of public policy in designing policies that ensure the soundness of the banking system.
These policies may include deposit insurance, a lender of last resort function and prudential regulation, including imposition of a minimum capital ratio. However, such policies may themselves contribute to the impact of the credit channel. For instance, consider a bank that is required by regulation to hold at least a 4 percent tier 1 equity to risk-adjusted assets ratio (as under the Basle regime) and which initially has a 5 percent equity ratio. The bank then experiences a shock to its capital base as a result of a negative economic shock that reduces its equity ratio to 3 percent. If it cannot access new equity immediately, it has no choice but to reduce the size of its loan portfolio by a combination of extending fewer new loans, reducing loan rollovers and calling in existing (callable) loans. The initial negative economic shock thereby is magnified as the credit supply is diminished. By contrast, without the 4 percent minimum, the bank may be able to undertake less drastic short-term adjustment. In some circumstances, therefore, there may be a trade-off between soundness (minimum capital) and monetary policy (credit channel) concerns. Nevertheless, policies which promote bank soundness – for instance, through a requirement for directors’ attestations regarding adequacy of risk management systems – in general, reduce the potential for shocks to impact on bank capital in the first place, so helping to mitigate both soundness concerns and credit market imperfections.
The credit channel literature has made great strides in recent years, but significant issues remain unresolved. Much of the literature to date has focused on the United States, which can be adequately modelled as a large closed economy. The credit channel has yet to be incorporated in a model of a small open economy with a floating exchange rate. Moreover, existing models generally only allow for either the bank lending channel or the balance sheet channel, but not both. To account for the bank lending channel, a model would need to explicitly incorporate financial intermediaries and bank lending, while balance sheet or financial accelerator effects could be captured by making firms’ acquisitions of capital depend on their net worth. The foreign sector could be accounted for by allowing at least some agents in the model to borrow from abroad. The development of such a model based on an amalgam of recent advances of the literature presents an agenda for a programme of future work. This programme, by incorporating financial market interactions into macroeconomic models, will enhance the understanding of the transmission mechanism of monetary policy and other shocks to the economy.