The bank lending channel suggests that banks play a special role in the transmission of monetary policy. In this theory, monetary policy has an effect on banks’ cost of funds in addition to the change in the risk-free rate, leading to an additional response in bank lending. The supply of intermediated credit therefore has a unique response to monetary policy. To analyze the bank lending channel, we study the response of banks to monetary policy in the context of mortgage funding and mortgage lending. We focus on lending in subprime communities, because it is a form of information-intensive lending which affects banks’ choices in funding sources and their response to changes in funding costs. Our paper helps explain how mortgage loan supply responds to monetary policy by addressing the role of banks in the transmission of monetary policy.
We consider how two functions of banks – deposit-taking and mortgage lending are interrelated. In our analysis, banks’ business strategies are characterized by how they fund mortgages and which types of mortgages they originate. “Traditional banks” use insured retail deposits, which we refer to as core deposits, to fund information-intensive loans. Consistent with this view, we find that traditional banks tend to extensively lend in communities with high proportions of subprime households, where public information about borrowers is limited. Alternatively, “market-based banks” use market debt such as brokered deposits, which we refer to as managed liabilities, to fund loans that are easier to evaluate. These banks tend to originate mortgages in communities of mostly prime borrowers, where more borrower information is publicly available. We define a bank’s core lending capacity as its ability to fund loans with core deposits; therefore, traditional banks have a large core lending capacity whereas market-based banks have already exhausted their core lending capacity. “Transition banks” are banks that operate between these two business strategies, where extensive lending is done in subprime communities but core lending capacity is sometimes exhausted.
One of the key differences between banks using these two business strategies is in their external finance premium. Banks that must borrow uninsured funds in order to make loans will have to pay an external finance premium. This is problematic for banks that lend extensively in subprime communities due to the information-intensive nature of this type of lending. Whereas prime mortgages tend to be underwritten based on a few quantifiable factors, subprime mortgages tend to be underwritten more so on non-quantifiable factors. This private information collected by the bank in the subprime lending process is not available to outside investors, making the value of the balance sheet of such lenders more difficult to evaluate. This implies that investors will charge a larger external finance premium for lenders that extensively lend in subprime communities.
For banks about to exhaust their core lending capacity, ongoing mortgage lending may require the payment of an external finance premium. Deposits are limited, which means that banks may have to switch from insured deposits to managed liabilities if they want to continue funding new mortgages (Jayaratne and Morgan, 2000). For these banks, shifting from insured retail deposits to managed liabilities creates an external finance premium. Therefore, when banks that lend in subprime communities need to switch from insured retail deposits to managed liabilities, their cost of funding can quickly increase.
A significant change in banks’ cost of funds can be brought about by a change in monetary policy, which is the basis for identifying the bank lending channel. A monetary tightening shrinks banks’ core deposits, forcing banks to rely more on managed liabilities and increasing their cost of funds. Our two differentiating factors, core lending capacity and lending in subprime communities, can be combined to predict which banks are likely to have the largest change in cost of funds due to monetary policy. Banks lending in subprime communities will likely face a larger external finance premium if they are required to borrow in the market and banks facing the limit of their core lending capacity are most likely to switch from deposit funding to market funding. If the bank lending channel exists, it most likely operates through transition banks.
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The Bank Lending Channel of Monetary Policy and Its Effect on Mortgage Lending
