Monetary Transmission Mechanism Flashcards
what is the monetary transmission mechanism?
the way in which changes in monetary policy, primarily managed through central bank interest rate manipulations, are transmitted to private sector banks
what are the three traditional assumptions of the monetary transmission mechanism?
- loans, cash and bonds are perfect substitutes
- banks are passive conduits of monetary policy
- 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
do the assumptions of the traditional monetary transmission mechanism align with empirical realities?
no - fail to explain why mon pol changes do not translate uniformly & often result in a greater than one-for-one effect
what do the three traditional assumptions fail to explain about monetary policy transmission?
they fail to explain why monetary policy changes do not translate uniformly and often result in a greater than one-to-one effect
do changes in monetary policy translate uniformly?
no
do changes in monetary policy result in a one-for-one effect?
no, often result in a greater than one-for-one effect
what are the 2 main channels for the MTM? what are the other channels?
- narrow lending channel (bank lending channel)
- tight policy forces banks to either vary funding from cheap to expensive or scale back funding
- broad lending channel (financial accelerator)
- tight policy increases wedge between cheap & costly sources of bank funding
- bank capital channel
- tight policy forces banks toward regulatory capital limits at which they must limit their lending
- risk channel
- tight policy influences banks’ & investors’ risk attitudes
what does EFP stand for?
external finance premium
what is the EFP?
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
why does the EFP exist?
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
which scholars said the EFP reflects imperfections in credit market that drive wedge between expected return received by lenders & costs faced by potential borrowers?
Bernanke & Gertler, 1995
what is the proof of why the EFP exists?
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
is the EFP exacerbated by adverse selection & moral hazard? why?
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
outline the Narrow Lending Channel.
- CB tightens monetary policy by shifting reserve supply left in the overnight market (either through 1. open market operations or 2. interest rate manipulation)
- a smaller supply of reserves means banks risk violating reserve/deposit ratios so deposits have to be scaled back
- 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)
- in either case supply of commercial loans from bank contracts
- greater than one-for-one transmission of monetary policy
what are the two options banks have to shift the supply curve of bank loans to the left in the NLC?
a. scale back lending to reflect lower deposit funding
b. maintain lending but switch to more expensive funding
give a one line summary of the narrow lending channel.
tight monetary policy forces banks to vary composition of their funding from cheap (deposits) to expensive (debt or equity) sources or scale back funding
what is the shadow banking pillar of the NLC?
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
what are the limitations of the NLC?
legal minimum R/D ratio
questions over whether deposit funding is still special
globalisation & diversified assets
explain why the NLC is most effective when a legal minimum R/D ratio exists.
↓ 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
why does it matter to the NLC if deposit funding is still special?
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
explain why diversification of bank assets because of globalisation has reduced the risk of funding banks through debt or equity.
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)
what is Ashcraft’s (2006) evidence that suggests limitation of NLC on an aggregate level?
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
what is the ‘is deposit funding still special’ limitation of the NLC?
perhaps deposit funding is less special nowadays because the external finance premium has been compressed
what are the different channels that the ‘is deposit funding still special’ critique of the NLC uses?
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
