Ebook The Bank Lending Channel in a Partially Dollarized Economy: The Case of Mexico
The purpose of this paper is to understand how the bank lending channel of monetary policy transmission is affected by the dollarization of the banking sector. Debate continues on the mechanism of monetary transmission for single currency economies. A study in a partially dollarized setting contributes to this broader debate by looking at one channel of monetary policy which is not present in a single-currency setting. This channel ties bank lending with the currency composition of a key component of bank liabilities, namely deposits. In particular, I motivate and test the mechanism by which banks, varying in their initial share of foreign currency deposits, respond differently to the same monetary policy shock. This response is not limited to changing the currency composition of bank liabilities or to altering more generally the make-up of these liabilities.
The constraints arising on the liability side will affect the asset side if bank assets are not decoupled from bank financing, which will be true in the presence of capital market frictions and restrictions. This generates economically interesting and potentially important effects of monetary policy on loanable funds, credit, and therefore on real activity in a partially dollarized economy.
How does monetary policy influence real activity in a standard economy and what novel aspect is introduced in a partially dollarized setting? There are three main channels of monetary policy, and the conventional story is the interest rate channel. The extent to which monetary policy can influence short-term real interest rates (because prices are sticky), alters the real cost of capital for firms and thus investment. Bank loans behave passively in this story and can be lumped together with bonds. Banks become important when intermediaries improve the allocation of capital because they can screen potential borrowers and monitor those which they choose to finance. This is the case when there are information frictions in credit markets, which create a gap between a borrower’s internal finance (retained earnings) and the more costly external finance.
The external finance premium facing a firm in need of funds for an investment project falls as its net worth increases. This reduces its need for external funding or allows it to secure its debt with greater collateral. The resulting inverse relationship between the external finance premium and borrower net worth gives rise to the second channel of monetary policy known as the firm balance sheet channel. For example, a monetary policy contraction raises interest rates, which increases interest payments on a firm’s debt and reduces its net worth. Likewise, contractionary monetary policy reduces asset values such as property, decreasing a firm’s net worth and its collateral. Both effects serve to decrease a firm’s demand for credit when monetary policy is tightened.
The third channel of monetary policy transmission is known as the bank lending channel, and was developed by Bernanke and Blinder (1988, 1992). Just as firms cannot frictionlessly raise external funds, so too banks face capital market imperfections. Because of agency costs, banks cannot perfectly make up for a loss in insured deposits with other uninsured sources of funds, such as CDs, subordinated debt and equity. In fact, agency costs may be more severe for banks because their assets are opaque and harder to value compared with non-financial firms. For example, when the Central Bank conducts contractionary monetary policy, reducing reserves and hence deposits, loan supplies will be cut.
This inward shift in the bank lending schedule raises the cost of loans on top of the interest rate rise on bonds due to the monetary contraction. That bank loans will be restricted and their cost increased only matters if there are bank-dependent firms that would otherwise not invest. This may be because they cannot access arms’ length financing from the capital markets. Therefore, changes in bank lending will affect real activity. To summarize, the standard interest rate channel of monetary policy is amplified by the firm balance sheet channel and the bank lending channel. The latter two channels are collectively known as the credit channel (Bernanke and Gertler, 1995, provide an excellent survey).
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