Bank Lending and Monetary Policy: Evidence on a Credit Channel

While there is widespread agreement that banks play a key part in the transmission of monetary policy actions to the economy, there is considerable controversy over the precise role that banks play. The focus of this debate is whether bank lending plays a special part in the monetary transmission mechanism. If a special lending or credit channel exists, changes in the willingness and ability of banks to extend credit may have implications for aggregate economic activity. Moreover, ongoing changes in the role banks play in financial markets may affect this credit channel and so alter the monetary transmission mechanism. Recent research on a bank credit channel has focused on two questions. Are certain borrowers so dependent on bank lending that any change in banks' willingness to lend immediately affects investment and spending decisions? And, do monetary policy changes directly constrain bank lending? Both conditions are necessary for bank lending to play a special role in the monetary transmission mechanism. Thus far, research on a credit channel has yielded mixed results. Some recent research provides support for the view that certain borrowers, such as small businesses, are very dependent on banks for financing. This finding suggests that disruptions in bank credit could affect economic activity. At the same time, there is conflicting evidence that bank lending is directly constrained by monetary policy actions. This article provides additional insight into the second question--whether bank lending is constrained by monetary policy. The article does so by analyzing how banks adjust the amount and terms of business lending when monetary policy is tightened. The analysis differs from previous research by using a more precise measure of monetary policy actions, which allows a more accurate identification of episodes of monetary tightening. Evidence presented in the article suggests that bank business lending is not constrained by restrictive monetary policy. The article concludes that monetary policy does not appear to operate through a special credit channel. The first section of the article examines the rationale for a credit channel and the implications of this channel for monetary policy. The second section reviews recent research on the key features of a credit channel: bank dependent borrowers and the ability of monetary policy to directly restrict bank lending. The final section presents new empirical evidence on whether monetary policy constrains bank business lending. BANK LENDING AND THE MONETARY TRANSMISSION MECHANISM The view that bank lending plays a special role in monetary policy has been part of policy debates for over 40 years. The existence of a lending or credit channel implies that ongoing structural changes in the banking industry may alter the monetary transmission mechanism and make it harder to implement monetary policy. The special nature of bank lending There is general agreement among economists and policymakers that monetary policy works mainly through interest rates. When policy is tightened through a decrease in reserve provision, for example, interest rates rise. A rise in interest rates leads to a reduction in spending by interest-sensitive sectors of the economy, such as housing and consumer purchases of durable goods. Banks play a part in this interest rate mechanism since a reduction in the money supply--which consists mainly of deposit liabilities of banks--is one of the principal factors pushing up interest rates. In this standard view of the monetary transmission mechanism, however, there is nothing unique about bank lending. Indeed, the interest rate mechanism does not depend on what assets banks hold; the same response would occur regardless of the proportions of a bank's assets that are held as loans or securities (Bernanke and Blinder 1988). In contrast to this description of the transmission mechanism, some economists and policymakers have argued that an additional policy channel works through bank credit. …