Monetary Transmission Mechanism

Question 1

what is the monetary transmission mechanism?

Answer 1

the way in which changes in monetary policy, primarily managed through central bank interest rate manipulations, are transmitted to private sector banks

Question 2

what are the three traditional assumptions of the monetary transmission mechanism?

Answer 2

1. loans, cash and bonds are perfect substitutes
2. banks are passive conduits of monetary policy
3. borrowers or lenders face no financial frictions so an increase in the interest rate in the overnight reserve market is transmitted one-for-one to the private sector

Question 3

do the assumptions of the traditional monetary transmission mechanism align with empirical realities?

Answer 3

no - fail to explain why mon pol changes do not translate uniformly & often result in a greater than one-for-one effect

Question 4

what do the three traditional assumptions fail to explain about monetary policy transmission?

Answer 4

they fail to explain why monetary policy changes do not translate uniformly and often result in a greater than one-to-one effect

Question 5

do changes in monetary policy translate uniformly?

Answer 5

no

Question 6

do changes in monetary policy result in a one-for-one effect?

Answer 6

no, often result in a greater than one-for-one effect

Question 7

what are the 2 main channels for the MTM? what are the other channels?

Answer 7

1. narrow lending channel (bank lending channel)

• tight policy forces banks to either vary funding from cheap to expensive or scale back funding

2. broad lending channel (financial accelerator)

• tight policy increases wedge between cheap & costly sources of bank funding

3. bank capital channel

• tight policy forces banks toward regulatory capital limits at which they must limit their lending

4. risk channel

• tight policy influences banks’ & investors’ risk attitudes

Question 8

what does EFP stand for?

Answer 8

external finance premium

Question 9

what is the EFP?

Answer 9

EFP: rl - r : additional cost paid by bank for external funding from investors compared to risk-free rate

wedge reflecting the difference in cost of capital internally available to firms vs firms’ costs of raising capital externally via equity & debt market

Question 10

why does the EFP exist?

Answer 10

to attract funding from debt or equity, banks must offer premium rates of return, rl (markup on the monetary policy interest rate)

reflects imperfections in credit market that drive wedge between expected return received by lenders & costs faced by potential borrowers (Bernanke & Gertler, 1995)

EFP will exist as long as external financing is not fully collateralised

Question 11

which scholars said the EFP reflects imperfections in credit market that drive wedge between expected return received by lenders & costs faced by potential borrowers?

Answer 11

Bernanke & Gertler, 1995

Question 12

what is the proof of why the EFP exists?

Answer 12

Assuming rl = r, in good state an investor makes 0, in a bad state they make C + R’ - x - (1+r)L

Bad state return is assumed to be negative such that C + R’ - x - (1+r)L < -C

So rl = r implies overall loss, to avoid loss must set rl > r, hence EFP

Question 13

is the EFP exacerbated by adverse selection & moral hazard? why?

Answer 13

yes

2 types of bank. For type G, x = xg, for type B, x = xb, and xg < xb (B more risky)

asymmetric information → investors cannot distinguish good & bad banks ⇒ same rl required of all banks

if both types in market in equal number investor exp profit is:

EINV = 1/4((1 + rl)L + C + R’ -
xg) + 1/4((1 +rl)L + C + R’ - xb) -(1 + r)L

but as r and hence rl increase, EBANK=1/2(R’ + x - (1 + rl)L) - 1/2C falls & turns negative first for G types

• beyond this point no type G takes a loan, i.e. there is adverse selection of bad banks in market

lender’s expected profit collapses to:
EINV = 1/2((1 + rl)L + C + R’ - xb) - (1 + r)L

this increases the EFP, rl - r & stretches out funding spectrum

Question 14

outline the Narrow Lending Channel.

Answer 14

1. CB tightens monetary policy by shifting reserve supply left in the overnight market (either through 1. open market operations or 2. interest rate manipulation)
2. a smaller supply of reserves means banks risk violating reserve/deposit ratios so deposits have to be scaled back
3. banks have 2 options, both mean leftward shift of supply curve of bank loans

a. scale back lending to reflect lower deposit funding

b. maintain lending but switch to more expensive funding (debt or equity)

4. in either case supply of commercial loans from bank contracts
5. greater than one-for-one transmission of monetary policy

Question 15

what are the two options banks have to shift the supply curve of bank loans to the left in the NLC?

Answer 15

a. scale back lending to reflect lower deposit funding

b. maintain lending but switch to more expensive funding

Question 16

give a one line summary of the narrow lending channel.

Answer 16

tight monetary policy forces banks to vary composition of their funding from cheap (deposits) to expensive (debt or equity) sources or scale back funding

Question 17

what is the shadow banking pillar of the NLC?

Answer 17

for more costly bank loans to propagate to lower consumption, production, employment etc. it must be that private sector cannot perfectly substitute bank loans with corporate bonds, equity issues, trade credit

such alternative known as ‘shadow banking’ (e.g. P2P finance provider, or issue a corporate bond in the corporate bond market)

arguably a credible alternative for multi-national corporations, but not for small firms & households who do not participate in shadow banking

• imperfect substitute for bank finance

Question 18

what are the limitations of the NLC?

Answer 18

legal minimum R/D ratio

questions over whether deposit funding is still special

globalisation & diversified assets

Question 19

explain why the NLC is most effective when a legal minimum R/D ratio exists.

Answer 19

↓ R necessitates ↓ D

BUT R/D minimums are not legal anymore (just for auditors & investors) (regulations changed)

largely abolished in practice so any floors are voluntary e.g. to satisfy auditors and investors

plausible but more flexible than regulatory minimum

Question 20

why does it matter to the NLC if deposit funding is still special?

Answer 20

perhaps deposit funding is less special nowadays because the EFP has been compressed

if deposits become relatively less important in bank funding then NLC diminishes in importance & CB monetary policy decisions will not induce shifts in commercial bank loan supply via this channel to the same extent as before

Question 21

explain why diversification of bank assets because of globalisation has reduced the risk of funding banks through debt or equity.

Answer 21

diversification of bank assets (because of globalisation) has reduced risk of funding banks through debt or equity (compreses hierarchy of funding costs - can offset losses on loans with profits made on loans in other markets)

emergence of large & internationally diversified banking groups means reserve requirements can be met through switching funds across banks in group ⇒ lower voluntary reserve holdings (less precautionary behaviour by banks)

Question 22

what is Ashcraft’s (2006) evidence that suggests limitation of NLC on an aggregate level?

Answer 22

NLC rests on the idea that some banks are constrained and must limit lending as due to shortage of reserves.

But this may not be true.

Ashcraft presents evidence that some unconstrained banks pick up slack in lending supply from constrained banks, limits plausibility of NLC on aggregate level

Question 23

what is the ‘is deposit funding still special’ limitation of the NLC?

Answer 23

perhaps deposit funding is less special nowadays because the external finance premium has been compressed

Question 24

what are the different channels that the ‘is deposit funding still special’ critique of the NLC uses?

Answer 24

globalisation of the banking system has made for more diversified bank assets
- in theory this reduces the risk in funding a bank through debt/equity and cuts cost of such finance relative to deposits
- so hierarchy of funding costs compressed and monetary tightenings that work through driving banks out of deposit funding gain less traction
- equity investor will be less worried about viability of bank if bank can offset losses on loans in the UK with profits made on loans in other markets around the world
- e.g. Midland Bank was bought out by HSBC when it moved its headquarters to the UK. Global bank whose fortunes are not so closely tied to the fortunes of the UK economy overall. HSBC can cross-subsidise its operations in the UK with profits made on its operations in the US or Asia

SIFIs (systemically important financial institutions), ‘too big to fail’
- due to their size governments know (and banks themselves and the markets know) they are Too Big To Fail (TBTF)
- too big to fail because hold so many assets and liabilities that if they went under and they didn’t pay out on their liabilities, then it would inflict too many losses on other actors in the financial system
- bankruptcy will always be averted via bail-out, but as investors know this they perceive lower x on their debt and equity and set a lower EFP

Question 25

what are SIFIs

Answer 25

systemically important financial institutions

Question 26

what is the ‘too big to fail’ critique of SIFIs and the NLC?

Answer 26

due to their size, governments, markets and the banks themselves know that they are ‘too big to fail’ (TBTF)

too big to fail because:
- they hold so many assets and liabilities, that if they went under and they didn’t pay out on their liabilities, then it would inflict too many losses on other actors in the financial system

• if the SIFI is a very diversified global bank, it would be unclear what the pattern of its liabilities is (hard to tell who takes a hit and who doesn’t when a global bank goes under, e.g. 08/09 banks)

bankruptcy will always be averted via bail-out, but because investors know this they perceive lower x on their debt and equity and set a lower EFP

Question 27

how could you evaluate the NLC limitation that internationally diversified banks are less risky?

Answer 27

internationally diversified banks are no less risky when there is a global downturn in output and prices

argument doesn’t work so well in truly global crises when all markets are falling simultaneously and you don’t get any self-insurance through having diversified operations

Question 28

how realistic is the ‘too big to fail’ assumption?

Answer 28

hasn’t always held

e.g. Lehman Brothers allowed to fail in autumn of 2008

Question 29

what is Ashcraft (2006) bank holding company evidence of the NLC?

Answer 29

Ashcraft (2006) bank holding company vs. those not in bank holding company

in US state laws often set upper limit on number of branches any one bank may operate ⇒ upper limit on bank size

scale economies in banking can be exploited through the formation of bank holding companies (BHCs), which pool funds across many smaller banks

implication: Small banks in BHC have access to more liquidity than banks outside BHC ⇒ measure lending channel as difference in response of bank lending to changes in mon pol across banks that do (not) belong to BHCs

inside bank holding company, impact of monetary policy tightening on bank lending growth is 0

interpretation: although banks have less liquidity to play with and they have to trim their holdings of deposits, they’re not dependent on deposits in the first place because they have good access to funding from within their bank holding company

Question 30

what is Loutskina (2005) evidence that is consistent with the existence of a NLC?

Answer 30

Loutskina (2005) shows that banks that are able to securitise a larger fraction of their loans are less affected by monetary tightening

Question 31

how can the empirical evidence for NLCs be evaluated?

Answer 31

how relevant are findings today given the research was in the 90s?

international conglomerate banks
- issue comes when global financial crisis hits (if all banks face constraint to R/D ratio)

Question 32

explain the Broad Lending Channel mechanism.

Answer 32

1. policy tightening means increase in risk free rate (r)
2. banks pass this on leading to a decline in asset valuation (because of discounting)
3. lower asset valuation mean banks offer less collateral to investors on debt, equity, etc
4. this worsens bas state returns for investors since C+R’-x-(1+r)L ⇒ ↑ EFP for non-deposit finance
5. banks pass this on to consumers as increase in interest rates greater than the rise in risk-free rates (financial accelerator)

Question 33

give a one line summary of the broad lending channel.

Answer 33

tight monetary policy increases wedge between cheap and costly sources of bank funding

Question 34

what are the implications of the financial accelerator principle & flight to quality effect?

Answer 34

distribution of wealth across firms / households / banks affects the strength of transmission mechanism

most exposed to flight to quality effect are those that start off with the lowest asset base, most resilient are those with plenty of assets

monetary policy efficacy limited in deep recessions

Question 35

why does the distribution of wealth across firms / households / banks affect strength of the transmission mechanism in the BLC?

Answer 35

larger net asset values offer larger collateral bases more resilient to monetary policy

flight to quality effect: after policy tightening finance flees low collateral agents in favour of those with ample collateral

Question 36

why is monetary policy efficacy limited in deep recessions in the BLC?

Answer 36

asset prices depressed in recessions ⇒ ↑ EFP offsets ↓ r from policy

likewise ↑ x (e.g. bad loan fears) ⇒ ↑ EFP

these effects may partly explain weak recovery despite loose monetary policy (King - bank rate increases conditional on fall in EFP)

Question 37

what are the limitations of the BLC?

Answer 37

size of bank & its collateral base affects strength of transmission mechanism (flight to quality)

larger financial agents with more substantial collateral bases are less affected by policy contractions leading to a flight to quality in financing
- agents most exposed to flight to quality effect are those that start with the lowest asset base, the most reliant are those with larger collateral bases and hence policy contractions disproportionately affect those agents with the lowest net worth
- global corporations and international banks are far less exposed

in deep recessions, monetary policy efficacy is limited because asset prices are already depressed due to lower consumer and business confidence, rising default and other economic uncertainties

Question 38

what is Kashyap & Stein (2000) flight to quality evidence of the BLC?

Answer 38

estimate extent to which bank lending growth over a 3 month period is linked to internal banks funds available that period

idea is that when monetary policy is tightened external finance harder to get so measured linkage should intensify

find that bottom 95% less able to lend

KS take this as evidence that tight policy generates financial accelerator effects, but that large banks are able to avoid such effects since although the collateral they can offer is diminished it is still sufficient to secure funding with the same EFP as before the policy tightening

Question 39

explain the Bank Capital Channel.