Ebook Trade Credit and the Bank Lending Channel
Opinion remains divided about how credit market imperfections influence the transmission of monetary policy to the real economy (see surveys by Bernanke (1993) and Kashyap and Stein (1994)). Many economists believe only the “money channel” (it posits that the cost of capital is the means by which monetary shocks are transmitted to the real economy) is important, in particular, that the financial sector is irrelevant. The money channel view holds that when the central bank reduces reserves, higher costs of funds induce banks to reduce their demand deposits (a liability). If prices are sticky, this short-run decline in real money balances raises real interest rates to slow interest sensitive spending and thus economic activity (see Mishkin’s (1998) textbook summary of transmission channels).
“Credit channel” proponents believe that credit also plays an important part in the propagation of monetary shocks into the real economy (see, e.g. Bernanke and Gertler, 1995). The “broad credit channel” branch of the literature stresses that some firms are subject to an external finance premium, defined as the cost spread between a firm’s external funds (bonds, loans, and equity) and its internal funds (retained earnings). According to this theory, the higher risk increases information problems during a recession, thus increasing the affected firms’ external finance premium. This then amplifies the policy-induced impact of market rates on firms. Firms without access to open market credit are more subject to information problems and thus this “financial accelerator”.
Another credit channel is the "bank lending channel". Many of its proponents e.g. Bernanke and Blinder (1988), Kashyap and Stein (1995), assert that banks' asset decisions also play an important role in monetary policy independently of the cost of capital. The theory predicts that a reduction in reserves induces banks to scale back lending activities. And this disproportionately affects a class of firms that cannot readily switch to other funds, those without access to credit markets. Small manufacturers, for instance, may be more dependent on banks than other firms, and without alternative financing, they may be forced to limit desired investment (or current production) for a given market interest rate.
The bank lending channel is the most disputed transmission mechanism in recent empirical research. Romer and Romer (1989) argue that loans do not play an important role since they find that a policy tightening initially impacts interest rates through deposits, not loans. Bernanke and Blinder (1992), though, find that policy shocks affect bank portfolios systematically, which money channel theories cannot explain. Moreover, they find banks’ securities is the type of asset responsible for the immediate post-tightening decline in their balance sheets and that real activity sags later, at about the same time as the reduction in loans. It is, however, difficult to disentangle whether firms are affected by the slow-down in activity (inducing a reduction in credit demand) or from a loan supply reduction (as predicted by the bank lending channel). Kashyap, Stein, and Wilcox (1993) ingeniously solve this identification problem using commercial paper. They show firms issue more of this substitute credit during monetary contractions, thus suggesting that firms’ lower activity is due to a loan supply reduction and not that their loan demand is reduced by the activity slowdown. Oliner and Rudebusch (1996), though, discovered an error in composition in the Kashyap et al analysis; since only large firms issue commercial paper, its rise cannot inform about small firms, those shown by Gertler and Gilchrist (1994) to suffer the loan growth reductions. Gertler and Gilchrist find that large firms actually accelerated bank lending. Thus, the findings to date still allow interpretation of small firms’ bank loan reduction as due to lower demand from slower activity.
We make a simple test of the bank lending channel using a substitute credit following Kashyap, et al, but with a substitute also available to the firms suffering the lending decline. Trade credit (TC), is a loan a supplier provides to its customers in conjunction with product sales. TC is available to small firms yet its high cost (see part II) makes it unattractive for short periods beyond its intended duration. Small firms do utilize TC: those small firms surveyed by Davey (1989) seem to favor it second after bank loans. Our test exploits firms’ reluctance to switch from loans to an imperfect substitute: since TC is small firms’ only alternative, their higher TC would identify diminished loan growth during tight money as due to restricted loan supply. Accordingly at times of tight monetary policy, if the bank lending channel theory is correct, we should see small firms increasing TC and large firms, with assumed alternative credit, should avoid TC.
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