bank lending channel

What is the bank lending channel of monetary policy? Should we expect quantitative easing to give rise to a bank lending channel?
Introduction
The global financial crisis that followed the infamous collapse of Lehman Brothers in 2008 shook the very roots of the modern financial world. As a result, central banks across the globe were forced to re-evaluate and introduce new strategies in order to neutralise the damaging effects this crisis could potentially have had, and this process continues to this day. In the UK, much academic focus has been devoted to critically appraising the Bank of England’s monetary policy; following the weakening of various big-name UK banks, the BoE has instigated various rounds of quantitative easing in order to alleviate such financial institutions from the inevitable tightening that came about as a result of the crisis. The focus of this paper will be on the bank lending channel of monetary policy in particular with its fundamental link to quantitative easing the centre of critical analysis in the context of wider monetary policy as a whole. In order to analytically debate this question, one must begin by defining the key terms proposed in the question. Quantitative easing is essentially a means by which a central bank can ‘pump money’ into the economy directly. To clarify this simplification, one has to perceive QE as ‘an asset swap that alters the composition of the private sector’s financial assets, but does not add net financial assets’ (Roche, 2011). The conventional method by which this is carried out occurs through the purchase of assets, predominantly government bonds, (in the UK these are referred to as ‘gilts’), using money that is created out of thin air. The financial institutions that sell those bonds then have ‘new’ money in their accounts and this increases the money supply overall. The monetary policy transmission mechanism is fundamentally the umbrella term for the ways in which interest rate changes affect economic activity and inflation. This area is split into various channels that will be detailed further in this essay. One of those channels however, the bank lending channel, is primarily the focus of this question. The BLC is one part of the ‘credit channel’ that works in tandem with the interest rate channel. The BLC alone operates through changes in loan maturity: the detailed explanation of this mechanism will be discussed later on in this paper. Overall, this essay will argue that QE will inevitably give rise to a bank lending channel, but the BLC is less significant in the wider context of monetary policy. Despite the number of limitations on the BLC, it remains an effective channel of monetary policy; nevertheless it continues to be far from being the most potent approach to monetary policy implementation today.
Explanation of the mechanism of Quantitative Easing
This paper will begin with a thorough examination of quantitative easing as one method of monetary policy implementation, and will then progress into analysis for the bank lending channel in particular. Hence one must begin by comprehensively grasping the notion of quantitative easing before moving any further. QE, as touched upon in the introduction earlier, is, simply put, a means by which for a central bank such as the BoE to ‘pump new money’ into an economy. The way this works is rather complex however. Initially, a central bank purchases assets using electronic new money. This is designed to inject money directly into the economy. The central bank purchases assets from private sector businesses, including insurance companies, pension funds, high street banks for example. The central bank could even buy assets from a non-financial firm in some cases. Most of the assets they purchase are government bonds however, commonly referred to as ‘gilts’ in the UK. Bonds are conventionally perceived to be a safer investment, holding lower risk and longer maturity periods. When a bank purchases these assets, demand laws mean that their prices are increased. Given the inverse relationship between prices and yields, an increase in the price of these assets means that yields are lower, entailing that the returns to be gained on those assets falls. This then encourages the sellers of assets to use the money they receive from the bank to instead switch into other financial assets, such as equities in the shape of company shares or even corporate bonds. These purchases further drive prices upwards, in turn causing their respective yields to decrease. The lowering of yields is the significant aspect of this mechanism; lower yields reduce the cost of borrowing for businesses and the householder as interest rates begin to fall. The resultant fall in the cost of borrowing provides an incentive for both businesses and households to spend more and invest. The BoE could compliment this move further by purchasing debt, e.g. corporate bonds aimed at improving conditions in capital markets, making it easier for companies to raise money that they could then use to invest in their businesses. The noticeable distinction between quantitative easing and open market operations as part of an expansionary monetary policy is heavily down to the different time-scale of the two mechanisms. Open market operations typically involve a central bank buying short-term government bonds with a view to lower short-term market interest rates. However, when short-term interest rates are at or close to zero, normal monetary policy in this sense will render itself ineffective. This is when quantitative easing enters the equation as it may be used to further stimulate the economy through the purchase of assets that hold a longer maturity, rather than short-term government bonds and thereby lowering long-term interest rates further out on the yield curve. Recent analysis has argued that the use of quantitative easing since the crisis of 2008 has indeed mitigated some of the adverse effects of the crisis. It is significant to note that the initial bout of quantitative easing in 2008 was the first of its kind in the UK.
The Bank Lending Channel as a Transmission Mechanism of Monetary Policy & Its Restrictions
The transmission mechanism of monetary policy elucidates how changes in nominal variables within the financial sector (such as nominal interest rates) would lead to changes within the real economy (Ireland 2008). Necessarily then, the bank lending channel is a type of transmission mechanism – it theoretically channels excess reserves or capital that banks have acquired through their sale of assets, in to the financing of new loans to both businesses as well as consumers. At an oversimplified level, more loans and more credit available in the economy means that Investment as a component of Aggregate Demand would increase, in conjunction with an increase in consumption since households now would have greater access to cheaper loans. Hence, as the bank lending channel channels liquidity in the economy (through the sale of assets) in to commercial banks’ balance sheets, incentivizing them to lend more significantly, there prospectively should be an increase in Aggregate Demand due to lower interest rates, meaning higher Investment by firms (due to lower borrowing costs) and higher consumption by households (due to the same lower borrowing costs). Hence, through a nominal change (interest rates reducing due to QE), in theory, there would be a change in the real economy in terms of an increase in price levels, Aggregate Demand and hence, income.
The bank-lending mechanism itself follows the procedure, in a simplistic sense, of an increase in bank deposits, and an increase in bank reserves, both leading to more capital for banks to finance new loans with. As new loans are financed, Investment by firms goes up and hence, increases Aggregate Demand. Through the unconventional nature of monetary policy in quantitative easing, the mechanism of the bank-lending channel is slightly complicated – in essence, an increase in bank reserves through the sale of financial assets to the Central Bank means that banks and other institutions will want to invest in more assets. As time goes by and QE progresses, this forces the price of shares to go up, resulting in the yield of these assets and their interest rates to decrease. This in essence leads to a higher amount of bank deposits because people are either now consuming their income or saving it in banks. As a result, this higher amount of bank deposits gives banks more capital to finance new loans with. In the medium-run, this should lead to an increase in Investment by firms because of the lower opportunity cost of borrowing, thus leading to further increases in Investment and Aggregate Demand (Mishkin 2013). Although the relevance of the bank lending channel is limited in the space of quantitative easing policy (because it requires specific conditions wherein it works effectively, which shall be discussed and detailed later in this work), it still holds significance because of its implications for quantitative easing: in particular, it implies that monetary policy such as QE will have a greater effect on expenditure and loan demand by smaller firms. Since smaller firms are more dependent on bank loans than larger firms who can get funds directly through stock & bond markets, these smaller firms would likely benefit the most from quantitative easing loosening monetary policy. Essentially, since small and medium sized enterprises (SMEs) have a more elastic demand for loans, as the cost of borrowing decreases, these firms will likely increase their demand for bank loans more than larger firms (Bank of England 2012). Hence, although the BLC can be seen as an effective means by which to stimulate the real economy, the BLC has its own set of restrictions as well.
The BLC itself is restricted by several factors, including future expectations, the risk appetites of banks at the time, other exogenous factors and transmission mechanisms that might work more effectively, as well as inherent problems within the channel itself. For instance, future expectations of Aggregate Demand going down would likely make banks more hesitant to issue new loans. This would be because of a higher risk premium associated with these new loans for the increased risk of default (based on the outlook of AD), as well as the fact that banks themselves will want to keep or maintain a capital reserve so as to cushion itself from the negative or adverse effects of a recession. Similarly, the risk appetite of banks themselves as quantitative easing is occurring will affect the effectiveness of the bank-lending channel – more risk-averse banks will resist issuing new loans. Similarly, exogenous factors such as possibilities of litigation and other exogenous influences on monetary policy would affect the BLC. Specifically, the Basel III Capital Requirements would either incentivize banks to retain their excess reserves as a capital buffer, creating a disincentive to finance new loans with these reserves, or creating an incentivize for banks to force higher borrowing costs on its customers. Lastly, inherent problems with the channel itself would limit the effectiveness of the BLC – for instance, it relies mostly on the elasticity of loan demand that SMEs exhibit, as opposed to that of larger corporations that can exploit the bond & stock markets. However, since SMEs are essentially the nerve center of the economy, this is not a particularly detrimental restriction on the demographics that the BLC affects directly (Schreyer 1996). The largest positive spillover effect of the channel would probably be present in this sector of the economy (i.e., lower cost of borrowing for these firms, financing higher employment), potentially propagating the effect to other sectors, thus increasing Aggregate Demand further than previously thought.
Alternate Transmission Mechanisms that Quantitative Easing Could Birth
Where the bank-lending channel holds importance contemporarily, the interest-rate channel was one of the most widely held interpretations of the monetary transmission mechanism previously (Bernanke & Gertler 1995). In essence, the traditionally held view posited that as the real interest rate is lower if monetary policy is eased, Investment by firms goes up because of the lower cost of borrowing, which then leads to Aggregate Demand increasing and thus stimulating the economy. However, since real interest rates affect spending directly, a central bank commitment to future expansionary monetary policy can raise expected inflation, thereby lowering the real interest rate even when the nominal interest rate is fixed at or close to zero (Mishkin 2013). Hence, even when nominal interest rates are seemingly too low to stimulate growth and incentivize consumers to consume, the additional means of the interest rate mechanisms’ working via expected inflation and hence increasing real interest rates adds an extension of the classic tool of interest rate manipulation to the arsenal of a monetary policy setting committee.
Despite the previously widespread acceptance of the interest rate channel as being the sole monetary transmission mechanism, this channel has, since Bernanke & Gertler’s 1995 paper, met criticism as being far too limited to explain some macroeconomic responses to monetary policy shocks. For instance, the size of changes in the real economy is disproportionately great compared to the relatively small changes in open market interest rates attributable to changes in monetary policy. Similarly, the key components of GDP do not respond to interest rate changes immediately. In particular, they usually respond only after the effect of a change in interest rates is gone. Finally, monetary policy adjustments that affect short-term interest rates have large effects on variables that should respond to long-term interest rates, such as residential investment (Bernanke & Gertler 1995). Hence, the reliance on other alternate means of explaining macroeconomic responses to monetary policy shocks or changes, such as the emergence of the credit view, which includes the bank-lending channel, as well as a notable separate channel that has received attention in academia – the balance sheet channel.
The balance sheet channel, along with other credit channels, introduces the idea of asymmetric information in to models of macroeconomic response to monetary policy. For instance, the balance sheet channel relies on the concepts of moral hazard and adverse selection reducing, hence incentivizing banks to lend to firms due to the lower risk of default. For instance, as interest rates climb, the only firms that are still willing to raise capital at an irrationally high interest rate are firms that need that capital the most, and hence are firms that are in the most dire need of a bailout. These firms are also, as an extension to the previous statement, the least likely to fully pay back their loans. Hence, if adverse selection and moral hazard risks are high for a bank that is lending to a firm, it is likely that the bank will choose to forego the loan entirely due to the riskiness of the debt. On the other hand, as firms get wealthier, they are less likely to have big moral hazard or adverse selection risks, and hence are more reliable borrowers for banks to lend to. Hence, the balance sheet channel itself is composed of the real interest rate falling following an increase in quantitative easing. This in turn should lead to the price of shares increasing (because of households and financial institutions or otherwise preferring to invest their money in equities as opposed to bonds or gilts that have a lower real interest rate), meaning that firms who issue shares see an increase in their net worth. This increase in a firm’s net worth brings the concept of asymmetric information in to the debate – their higher net worth means that the their adverse selection and moral hazard risks are reduced, meaning that banks would be more likely to lend to this firm, thus increasing its investment. This sequence of events can also generally be extrapolated to the macroeconomic level – as firms’ net worth increases, costs of borrowing are reduced due to lower risk premia. This leads to higher lending by banks and higher Investment by firms, increasing Aggregate Demand (Mishkin 2013). Therefore, the balance sheet channel is also a plausible mechanism for monetary policy transmission. Not only does it effectively explain how a reduction in information asymmetries across an economy can stimulate output, but it also considers the fact that the magnitude of changes in the real economy is much larger relative to the change in interest rates. In addition, it also integrates the concept of short-term interest rates having effects on variables that should respond to long-term interest rates (i.e., a firm investing in more capital based on the reduction of short term open market interest rates).
Quantitative Easing & The Bank Lending Channel in its Current Context
In the backdrop of the relatively sudden Financial Crisis of 2007, it became clear that conventional monetary policy would fail to stem the possible losses in productivity that most economies would face. Since bank-lending reduced quite heavily following the collapse of the sub-prime mortgage market, consumer spending as well as firm Investment was no longer financed due to the associated risks with financing new loans in the outset of the recession (Bank of England Q3 Bulletin 2011, p. 207). Similarly, inflation reduced direly (Stock & Watson 2010). Hence, following Japan’s lead in 2001, quantitative easing was announced by both the Federal Reserve, as well as the Bank of England, in response to low output and to stimulate inflation to meet pre-determined inflation rates. In essence, this was a response to the fact that their risk-free short-term nominal interest rates were at or close to zero, in conjunction with the fear that inflation would fall below target, hence, theoretically stimulating Aggregate Demand.
The Bank of England’s Asset Purchase Facility in particular is based largely on the Bank buying mostly gilts and other high quality assets from financial institutions such as pension funds, insurance firms and banks (Bank of England Q3 Bulletin 2011, p. 200). The hope is that doing so will increase these firms’ liquidity and their willingness to finance new loans. The program went about doing this by engineering new electronic money and financing the purchase of assets from the private sector. This in turn would firstly raise the price of gilts and hence their interest rate or yield. This in turn makes it easier for firms to raise capital, because the yields of bonds and similar assets are lowered, with their prices simultaneously increasing. As was outlined earlier, this rise in prices of other assets makes consumers switch to shares, whose price in turn also rises, encouraging consumption and thus the possibility of inflation rates rising and meeting the predetermined target of 2% set by the Bank of England. This in effect forces investors from safe assets to riskier assets – safer assets being short-maturity gilts. The rise in gilts buying increases the price of gilts that are slightly longer-maturity as well, thus further decreasing demand for these gilts and effectively decreasing the longer-term interest rate as well further out on the yield curve (Guardian 2008). This effect would likely not be present if the Bank just engaged in open-market operations, lowering the short-term interest rate, and hence is potentially more effective in terms of encouraging consumption and possibly bank-lending as well. This is due to the concepts of adverse selection and moral hazard of individual investors that have more wealth after selling their assets, thus these risks are lowered through QE. Similarly, quantitative easing can also have an effect on the inter-bank overnight lending rate, thus incentivizing banks to lend to financially weaker institutions, with these institutions likely paying a higher interest rate as well. Thus, the presence of a bank-lending channel is a highly likely and probable event, especially in the context of the Bank of England’s Asset Purchasing Facility. This is done through the encouragement of consumption (thus likely leading to consumer or household lending by firms), the reduction in the costs of borrowing for businesses, as well as the higher incentive to lend to financially weaker bodies. All of this in turn has reflected in a less severe recessionary downturn, as is propagated by the Fed (Stein 2012).
Large-scale asset purchasing does have its risks and limitations however, and hence, should be treated with caution and controlled carefully. For instance, new litigation factors such as Basel III Regulations, as well as other nationally binding regulations are likely to limit the effect of quantitative easing in their respective countries. This is due to the fact that capital regulation limits the capacity with which banks can finance new loans, thus hindering the stimulation of AD. In particular, higher capital regulations mean that banks will likely have to retain more of their excess reserves as capital, as opposed to being able to finance new lending with it (Slovik & Cournède 2012). The same case can be made if higher reserve ratio requirements in some countries were to be instituted. Other risks of quantitative easing include the possibility of overestimating the effectiveness of the program, thus increasing inflation more than desired. Similarly, a decrease in interest rates would also lead to a decrease in the exchange rate of a floating currency – hence, quantitative easing would possibly increase net exports by decreasing import demand and helping net exporters, as well as debtors whose debts are in that currency. However, on the flipside, a devaluation of the currency of a nation would also lead to detrimental effects on creditors of that currency, as well as holders of that currency, because the real value of their holdings would decrease. Similarly importers would also be affected due to the higher relative cost of importing goods now (Bank of England Q3 Bulletin 2011, p. 206). An important last caveat to consider is the fact that if quantitative easing is pursued as a means of stimulating Aggregate Demand, it might fail due to the possibility that banks remain unwilling to lend to businesses and households in the economy, thus failing to stimulate demand.
Although quantitative easing has been effective to mitigate some of the risks that the Subprime Mortgage Crisis and the subsequent recession presented, it has risks of its own and might have a dampened effect on the real economy given the current confidence conditions of the global economy. In particular, the bank lending channel would expect to give rise to an increase in AD through higher lending. However, because of the as of yet high risks associated with lending, and the low consumer and business confidence that permeates the economy, there has been limited effect. Although the economy of both the US and the UK have recovered, albeit slowly, an uptake in the rise of the price of equities is not necessarily correlated with an increase in business confidence (BBC Market Data 2013). Rather, it can be seen as a reflection of the higher amount of liquidity in the market. Thus, although quantitative easing has been pursued since 2009, we are yet to see a large shift from consumers investing in shares, to consumers consuming, thus likely boosting lending and hence Investment as well by firms. Therefore, although quantitative easing has been successful in mitigating some of the large risks presented by the Global Financial Crisis, it is as of yet to largely influence or stimulating Aggregate Demand for the better (Bank of England Q3 Bulletin 2011, p. 211). Similarly, in the context of the current conditions of the global markets (in terms of litigation and information asymmetry risks), it is unlikely that we should expect to see quantitative easing give rise to a potent or large bank lending transmission mechanism.
Conclusion
The central argument this paper asserts, as already made clear in this essay is the fact that QE does inherently give birth to a possibility of a bank lending channel arising, however a more rational examination of the mechanism would conclude that this outcome is not by any means necessary or guaranteed. As explained, there are various other channels that may also arise, with the balance sheet channel one amongst many other possibilities. Given the focus of the bank-lending channel in this question, it would be intriguing to perhaps adopt a different perspective on the issue. One could reasonably also question whether quantitative easing alone is necessary for a bank-lending channel to form; further research could be carried out in order to ascertain other possible means by which a bank-lending channel could become evident. It seems viable that another scenario of a bank-lending channel without the presence of QE can exist and so this becomes a possible area of further economic research. For the purpose of this essay however, it remains critical that central banks execute quantitative easing in the correct manner, in the hope that general macroeconomic variables continue to illustrate signs of recovery as well as future prosperity. So far, in the UK atleast, quantitative easing seems positive; growth figures, albeit relatively lethargic, are nevertheless an indication of the policy’s success to date and the hope is that this will continue in the long run.

Citations
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Citations: Bernanke, Ben S., and Mark Gertler. "Inside the Black Box: The Credit Channel of Monetary Policy Transmission." Journal of Economic Perspectives 9.4 (1995): 27-48. Calstatela.edu. California State University, Los Angeles. Web. "Dow Jones Industrial Average - 12 Months." Chart. BBC.co.uk. British Broadcasting Channel, 27 Nov. 2013. Web. &lt;http://www.bbc.co.uk/news/business/market_data/stockmarket/2/twelve_month.stm&gt;. Elliot, Larry. "Quantitative Easing." TheGuardian.com. The Guardian, 8 Jan. 2009. Web. Ireland, Peter N. "Monetary Transmission Mechanism." Dictionaryofeconomics.com. Palgrave Macmillan, 2008. Web. Mishkin, Frederic S. The Economics of Money, Banking and Financial Markets. 10th ed. Boston: Pearson, 2013. Print. Roche, Cullen. "Understanding Quantitative Easing." PRAGMATIC CAPITALISM. N.p., 2011. Web. Schreyer, Paul Slovik, Patrick, and Boris Cournède. "Macroeconomic Impact of Basel III." OECD Economics Department Working Papers (2011): n. pag. Ideas.repec.org. OECD Publishing, 14 Feb. 2011. Web. United Kingdom. Bank of England. Monetary Policy Committee. The Transmission Mechanism of Monetary Policy. By Eddie George, Mervyn King, and David Clementi. BankofEngland.co.uk, 2012. Web. Watson, James H., and Mark W. Watson. "Modeling Inflation After the Crisis - Working Paper 16488." NBER Working Paper Series (2010): n. pag. Nber.org. National Bureau of Economic Research, 2010. Web