Monetary policy and bank lending.

Bernanke, Ben

Over the last decade or so, NBER researchers have analyzed the effect of financial conditions, particularly the characteristics of borrowers' and lenders' balance sheets in macroeconomic performance.(1) The result, I believe, is a much richer understanding of the sources of aggregate fluctuations. For example, ten years ago the leading theory of the determination of business fixed investment implied that the main factors affecting investment were the marginal product of capital and the real interest rate. Absent large unexplained fluctuations in capital's marginal product, this neoclassical theory was hard pressed to explain the volatility of investment over the business cycle. Recent empirical research has shown instead that balance sheet conditions, such as the firm's indebtedness or its access to internal finance, have a major influence on its investment decisions.(2) It seems likely that cyclical changes in balance sheets or cash flows, perhaps in interaction with the illiquid nature of capital investments, ultimately will provide an explanation of the cyclical volatility of investment spending that is superior to what the neoclassical model can offer.

The research I report on here, on the link between monetary policy and commercial bank lending, is a relatively small subtopic of this larger research program on financial-real interactions. It shares with the larger program the idea that balance sheets matter, as well as the broader conviction that--because the structure of financial arrangements affects the transmission of information and the incentives of market participants--financial conditions do have effects on the real economy.

The Channels of Monetary Transmission: Money Versus Credit

The question I take up here is a very old one: how does monetary policy affect aggregate demand? The standard answer is that the Federal Reserve works its magic by changing the supply of the medium of exchange relative to the demand. According to this story, to slow down the growth of aggregate demand (for example), the Fed uses open market sales to drain reserves from the banking system, reducing the money supply. This shortage of liquidity is presumed to drive up short-term--and possibly, through expectational effects, longer-term--interest rates. Higher interest rates are then presumed to depress aggregate demand by raising the cost of funds relative to the returns to capital (including housing and consumer durables). I will refer to this standard channel as the "money channel" of monetary transmission.

Without necessarily denying the existence of this conventional money channel, recent research has addressed the possibility that there is an additional channel of monetary policy transmission, which I will refer to as the "credit channel." In contrast to the money channel, which operates through the liabilities side of bank balance sheets (deposits), the credit channel (if it exists) operates through the asset side of the bank balance sheet (loans and securities). This credit channel relies on two assumptions.

The first is that banks do not treat loans (for example, to commercial and industrial firms) and securities (such as Treasury bills) as perfect substitutes in their portfolios. This assumption is quite realistic: banks hold securities primarily for liquidity, for collateral, and to satisfy various legal requirements, while loans are held primarily for their expected return.

The second assumption is that potential borrowers, such as business firms, are not indifferent between bank loans and the issuance of open-market securities, such as equities or corporate bonds, as a means of raising funds. Again, this assumption is realistic: many firms, especially smaller ones, have essentially no access to open-market credit and must rely entirely on banks or other intermediaries for funds. In part, this is because of the large fixed costs of open-market issues, as well as because of the comparative advantage that banks have developed in assessing the quality of business loans, which reduces the net cost of borrowing through a bank. Even large firms do not appear to be indifferent about their sources of funds: for large firms, bank loans may provide short-run liquidity not available from public issues. Studies of stock market data also have shown that the announcement of large new bank loans raises equity values, suggesting that bank loans are a useful method of signaling to the market that the firm's prospects are good.

Adding these two plausible assumptions to the standard macro model leads to a new channel of monetary policy transmission: the credit channel.(3) The credit channel works as follows: suppose again that the Federal Reserve wants to depress aggregate spending, and therefore has drained reserves from the banking system. To the extent that the loss of reserves forces a contraction in bank liabilities (deposits), it must lead simultaneously to a parallel contraction in bank assets (loans and securities). If loans and securities are not perfect substitutes for banks, then in general, as banks lose deposits, they will try to reduce both categories of assets. In particular, banks may cut down new lending, fail to renew old loans, and in extreme cases even call outstanding loans.

If firms were indifferent about their source of finance, then a cutback in bank lending would not affect their behavior; they simply would switch to alternative credit sources. However, if alternative forms of credit are more expensive to the firm, or simply are not available,(4) then a drying up of bank lending may force firms to cancel or delay capital projects, reduce inventories, or even cut payrolls. In short, the credit channel story says that contractionary monetary policy can force banks to cut loans, and that reduced bank lending in turn impels firms that are wholly or partially dependent on banks for credit to reduce their spending. Similar effects could operate in the consumer sector, to the extent that households are directly or indirectly dependent on banks for certain types of credit.(5)

The existence of a credit channel does not rule out the simultaneous existence of a money channel. Indeed, there could be other modes of monetary transmission operating as well: for example, the research on investment alluded to in my introduction suggests that changes in nominal interest rates may affect investment spending via their impact on balance sheets or cash flows, as well as through the familiar "cost-of-capital" effect. Putting these various channels together yields a picture of the operation of monetary policy that is potentially much richer than the simple textbook analysis.

Evidence for the Credit Channel

Does a tightening of policy by the Federal Reserve lead to a reduction in bank lending, as required by the credit channel story? Does a fall in bank lending lead potential borrowers to reduce their spending?

A number of researchers have investigated the timing between monetary tightening and bank lending. Blinder and I found that, during the pre-1980 sample period, a tightening of monetary policy (as indicated by a rise in the federal funds rate) was followed in subsequent months by a decline in bank deposits and a matching decline in bank holdings of securities.(6) Bank loans did not fall during the first months after a tightening; indeed, initially, loans rose slightly. However, within six to nine months, banks began to rebuild their security holdings and to reduce lending substantially. The timing of the fall in lending corresponded closely to a rise in the unemployment rate. Blinder and I interpreted this pattern as being consistent with the credit channel story, arguing that the relatively slow reaction of lending was the result of costs that banks faced in adjusting their loan portfolios in the short run.

A potential problem with our interpretation is that a similar pattern might arise if only the money channel was operative. Suppose for example that a Fed tightening raised interest rates and induced firms to delay investment projects. Then we would expect again to see a decline in bank lending follow the tightening of policy, except that in this case the decline in lending would be the result of a fall in borrowers' demand for loans, rather than a reduced willingness of banks to lend.

In an interesting attempt to resolve the identification problem, Anil K. Kashyap, Jeremy C. Stein, and David W. Wilcox examined the behavior of alternatives to bank lending following episodes of monetary tightening.(7) They argued that, if the source of the lending slowdown was a reduction in loan supply, as implied by the credit channel theory, then nonbank sources of credit should rise following policy tightening, as firms looked to alternative lenders. In contrast, if the reason for the slowdown in lending was a decline in credit demand, then all forms of credit extension should fall after a tightening of policy. These authors' empirical results favored the credit channel view, as they found that issuance of commercial paper in particular has tended to rise sharply following a tightening of policy. Mark Gertler and Simon Gilchrist found that much of the Kashyap-Stein-Wilcox result was driven by the relatively more severe impact of monetary tightening on small, bank-dependent firms (as opposed to larger firms with access to commercial paper markets).(8) Gertler and Gilchrist interpreted their results as being consistent with a combination of the existence of a credit channel for monetary policy and a tendency for small firms to be financially weaker than larger firms.

Another type of evidence favoring the existence of a credit channel follows from the cyclical behavior of various interest rate spreads. For example, several researchers have found that the spread between the commercial paper (CP) rate and the interest rate on Treasury bills of similar maturity has remarkably strong forecasting power for the real economy; in particular, an increase in the CP rate relative to the T-bill rate signals an impending recession.(9) While several factors may explain the predictive power of this interest rate spread, one possibility is the operation of the credit channel of monetary transmission: a tightening of policy that reduces bank lending should lead both to a wider spread between the CP rate and the T-bill rate, as a constricted loan supply forces borrowers to rely more heavily on commercial paper issuance, and to a subsequent economic downturn. Indeed, I show that this particular interest rate spread is closely linked to indicators of monetary policy.(10) Similar results, with a similar interpretation, obtain for other spreads such as the spread between the rate on bank CDs and the T-bill rate.

If we accept that a tightening of monetary policy reduces the supply of bank loans, there still remains the question of whether potential borrowers are forced to reduce spending, or whether they can switch without significant costs to alternative credit sources. The evidence here is more limited but suggests that there do exist "bank-dependent" borrowers who face significant costs of finding alternative sources of credit. Gertler and Gilchrist's finding that small firms suffer disproportionately from episodes of monetary stringency is consistent with this view. Similarly, Kashyap, Owen A. Lamont, and Stein found that bank-dependent firms, defined to be firms without bond ratings and with low reserves of liquidity, were much more likely than other firms to shed inventories during a period of tight money.(11)

The evidence that I have described here briefly is, of course, drawn from historical episodes. It is possible that, whatever the relevance of the credit channel in the past, institutional changes that have occurred over the last 20 years or so may have rendered the credit channel inoperative by now. For example, Christina D. Romer and David H. Romer have stressed the significance of the elimination of reserve requirements on banks' managed liabilities; now, if an open market sale drains reserves and reduces banks' core deposits, banks that wish to make loans still can obtain funds by issuing large-denomination CDs. Other institutional changes that may have weakened the credit channel are the increasing ability of banks to securitize assets and the proliferation of alternative sources of commercial credit, including, among others, junk bonds, finance companies, and asset-backed commercial paper.

While the strength of the credit channel no doubt has changed, I suspect that it remains a nontrivial part of the monetary transmission mechanism. The ability of banks to issue large CDs at a given interest rate, for example, likely is limited by the depth of the market and concerns about bank risk, while economic theory suggests strongly that there is a core of information-intensive loans that will be difficult to securitize. On the borrower aide, small firms still do not have access to junk bonds or asset-backed commercial paper; and finance companies, which do service small firms, have focused on more standardized lending rather than customized, information-intensive loans. Also, it should be remembered that institutional changes, particularly the offering by nonbanks of close substitutes for bank deposits, likewise have potentially affected the strength of the conventional money channel, so that it may be that the relative importance of the credit channel has not declined. In any case, we can hope that research on the alternative channels of monetary transmission will be of some help to policymakers as they try to cope with a rapidly changing financial environment.

The Credit Channel and the 1990 Recession

One of the striking features of the 1990 recession, documented by Cara S. Lown and me, among many others, is the sharp decline in bank lending.(12) Does this decline reflect the operation of the credit channel?

Interestingly, the answer appears to be no. Indeed, the 1990 recession may be one of the few postwar recessions in which a decline in bank lending engendered by tight monetary policy did not play a part. Evidence for the claim that the credit channel was not in operation during this recession includes: the decline of the federal funds rate well in advance of the recession; an apparent reluctance of banks to issue managed liabilities (contributing to slow M2 growth); weak growth of commercial paper and other nonbank forms of credit; and an unusual prerecession decline in the spreads between the CP and CD rates on the one hand and the T-bill rate on the other. Rather than the credit channel of monetary policy, Lown and I argue that two other types of financial developments contributed to the recession that began in 1990: first, a shortage of bank capital that constrained bank lending, particularly in the Northeast; second and more importantly, weakness in borrowers' balance sheets arising from high levels of indebtedness. To the extent that our diagnosis is correct, the 1990 recession illustrates the point made at the beginning of this article: that balance sheets play a potentially important role in business cycle dynamics.

1 Recent NBER volumes bearing on this theme include: Asymmetric Information, Corporate Finance, and Investment (1990) and Financial Markets and Financial Crises (1991), both edited by R. G. Hubbard and published by the University of Chicago Press for the NBER.

2 See, for example, S. Fazzari, R. G. Hubbard, and B. C. Petersen, "Financing Constraints and Corporate investment," Brookings Papers on Economic Activity (1988:1), pp. 141-195.

3 For a simple formal analysis, see B. S. Bernanke and A. S. Blinder, "Credit, Money, and Aggregate Demand," NBER Reprint No. 1205, June 1989, and American Economic Review Papers and Proceedings, 78, 2 (May 1988), pp. 435-439. An additional necessary assumption is that the Fed can affect the quantity or cost of funds available to the banking system.

4 The literature on the credit channel often has been related to the literature on credit rationing. However, credit rationing, in the sense of strict limits on credit availability, is not needed for this channel to operate; it is sufficient that credit obtained from alternative sources be more expensive than the bank loan.

5 The idea that bank lending plays a role in monetary transmission is not new; it was discussed under the rubric of the "availability doctrine" in the 1950s and can be found even in Keynes. However, because of developments in the economics of imperfect information and in econometric techniques, the theoretical and empirical bases for the idea are noticeably stronger than in the past.

6 B. S. Bernanke and A. S. Blinder, "The Federal Funds Rate and the Channels of Monetary Transmission," NBER Working Paper No. 3487, October 1990, and in American Economic Review 82, 4 (September 1992), pp. 901-921.

7 A. K. Kashyap, J. C. Stein, and D. W. Wilcox, "Monetary Policy and Credit Conditions: Evidence from the Composition of External Finance," NBER Working Paper No. 4015, March 1992, and in American Economic Review, forthcoming.

8 M. Gertler and S. Gilchrist, "Monetary Policy, Business Cycles, and the Behavior of Small Manufacturing Firms," NBER Working Paper No. 3892, November 1991.

9 B. M. Friedman and K. N. Kuttner, "Money, Income, and Prices After the 1980s," NBER Reprint No. 1731, July 1992, and J. H. Stock and M. W. Watson, "New Indexes of Coincident and Leading Economic Indicators," in NBER Macroeconomics Annual, Volume 4, O. J. Blanchard and S. Fischer, eds., Cambridge, MA: MIT Press, 1989.

10 B. S. Bernanke, "On the Predictive Power of Interest Rates and Interest Rate Spreads," NBER Working Paper No. 3486, October 1990, and in New England Economic Review, Federal Reserve Bank of Boston (November-December 1990), pp. 51-68. See also B. M. Friedman and K. N. Kuttner, "Why Does the Paper-Bill Spread Predict Real Economic Activity?" NBER Working Paper No. 3879, October 1991, and in New Research in Business Cycles, Indicators, and Forecasting, J. H. Stock and M. W. Watson, eds., Chicago: University of Chicago Press, forthcoming.

11 A. K. Kashyap, O. A. Lamont, and J. C. Stein, "Credit Conditions and the Cyclical Behavior of Inventories: A Case Study of the 1981-2 Recession," NBER Working Paper No. 4211, November 1992; also summarized in NBER Digest, February 1993.

12 B. S. Bernanke and C. S. Lown, "The Credit Crunch," Brookings Papers on Economic Activity (1991:2), pp. 205-239.