Recent research has ensured that market imperfections have a central place in the transmission of monetary policy through the credit channel. When there is imperfect information, alternative types of credit cannot be regarded as perfect substitutes and hence the choice of external finance on the part of the firm, and the availability and price of external funds offered by financial intermediaries will depend on factors such as the strength of firms’ balance sheets.
This has introduced the broad credit channel view, extensively surveyed in Gertler (1988), Hubbard (1995) and Kashyap and Stein (1994). Some firms with characteristics that prevent effective access to alternative markets for funds such as corporate paper or bond markets may be particularly dependent on bank finance under these circumstances and this gives rise to the bank lending channel.
It has been a characteristic of this literature to think of market finance and bank finance as the two available external finance options. For example theoretical research has been developed to allow bank lending and a capital market to co-exist even though the former is more expensive (see Besanko and Kanatas (1993), Bolton and Freixas (2000), Diamond (1991), Holmstrom and Tirole (1997), Repullo and Suarez (2000) and Hoshi, Kashyap and Scharfstein (1993)).
In these papers, capital market imperfections mean that access is denied to the capital market for firms with a weak financial position. These models predict that periods of monetary tightening will mostly affect financially weak firms (usually small firms) by restricting their access to bank lending and will cause a proportionate decline in aggregate investment, which has been corroborated by disaggregated data in Gertler and Gilchrist (1994) and Oliner and Rudebush (1996).