The Bank Lending Channel and Monetary Policy Rules: Evidence from European Banks

Article excerpt

Abstract There exist two main channels of the monetary transmission mechanism; the interest rate and the bank lending channel. This paper focuses on the latter, which is based on the central bank's actions that affect loan supply and real spending. The supply of loans depends on the monetary policy indicator, which, in most studies, is the real short-term interest rate. The question investigated in this paper is how the operation of the bank lending channel changes when this short-term indicator is allowed to be endogenously determined by the target rate the central bank sets through a monetary rule. We examine the effect that a rule has on the bank lending channel in European banking institutions spanning the period 1999-2009. The expectations concerning inflation and output affect the decision of the central bank for the target rate, which, in turn, affect private sector's expectations--commercial banks--by altering their loan supply.

Keywords Monetary policy rules * Bank lending channel * European banks * GMM methodology

JEL G21 -E52-C33


The monetary transmission mechanism is a powerful tool, since through this the monetary authorities can affect the economy with their decisions. This mechanism consists of various channels through which monetary policy is conducted, but the two main ones are: the interest rate channel (money view) and the credit channel (credit view). As far as the former is concerned, monetary policy changes affect aggregate demand through interest rates, whereas the latter accommodates the transmission of policy decisions by altering the availability and supply of loans (Hernando and Pages 2001). One of the sub-channels of the credit view is the bank lending one, which "stems from financial market incompleteness and relies on imperfect substitutabiiity1' (Gambacorta 2005).

The alteration in banks' loan supply is caused by changes in their reserves, which is initially affected by the decisions of central banks concerning the course of the interest rate. The goal of this paper is to investigate the effect on the operation of the bank lending channel, in case that central banks replace their primary monetary policy instrument they usually use with the target rate, the estimation of which is based on a set of macroeconomic variables. In other words, this paper investigates the impact of the bank lending channel on the economy when different types of interest rate rules are used as the monetary policy indicator. The formulation of these rules depends on data, the timing of which differs: they may be lagged, current, or forecasts and then the results are compared to one another. The empirical findings display that the bank lending channel operates better in the case when forward-looking rules are considered as the monetary policy indicator.

The rest of the paper is organized as follows: The following section reviews the literature concerning the bank lending channel and interest rate rules, whereas the next section analyses the data. The following section refers to the methodology used both for the estimation of the different types of rules and the lending channel. The final two sections present the results and conclusions, respectively.

Literature Review

The Bank Lending Channel

Concerning the bank lending channel, this study investigates how the decisions of the monetary authorities are transmitted and whether there is any impact of these decisions on economic activity. The operation of this channel mostly depends on the supply of loans and the factors that determine their course. In particular, a restrictive monetary policy leads to a reduction in bank reserves and deposits and, consequently, to a fall in loan supply. Therefore, businesses and consumers, who depend on bank lending, reduce their purchases of durable goods and purchases of capital for investment and, hence, output is also affected in a negative way (Golodniuk 2006). …