The banking channel of monetary policy tightening in the euro area

Remarks by Philip R. Lane, Member of the Executive Board of the ECB, at the Panel Discussion on Banking Solvency and Monetary Policy, NBER Summer Institute 2023 Macro, Money and Financial Frictions Workshop

Cambridge, Massachusetts, 12 July 2023

Introduction

I will focus in this speech on the banking channel of monetary policy.^[1] Starting in December 2021 with the announcement that net purchases under the pandemic emergency purchase programme (PEPP) would end in March 2022, the ECB has been tightening its monetary policy stance in response to the extraordinary surge in inflation amid the pandemic shutdowns, supply bottlenecks and, most importantly, the energy crisis triggered by Russia’s unjustified war against Ukraine.

For a given inflation outlook, the appropriate level and duration of a restrictive monetary policy stance depends on how powerfully and how quickly the economy responds to the tightening of monetary policy. In view of the predominant role of the banking system in credit provision in the euro area, how banks respond to monetary policy is a central issue in assessing the strength of the transmission mechanism. Accordingly, in our data-dependent approach to calibrating monetary policy, assessing the strength of the banking channel of monetary policy tightening is a first-order task for the ECB.

I will discuss some of the challenges in forming a quantitative assessment of monetary policy transmission via the banking channel.^[2] First, I will briefly review the various channels through which banks affect the transmission process. Second, I will assess how the considerable amount of monetary policy tightening injected over the last year is being transmitted in the euro area.

The bank-based transmission of monetary policy

Monetary policy affects investment and consumption decisions by setting the level of market interest rates and thereby steering borrowing costs across all economic sectors: this is the “cost-of-capital” channel. When banks pass on changes in the policy rate to their borrowers, the real economy is affected via the investment and production plans of firms, as well as through the decisions of households to financing consumption and real estate. Since for many firms and households the interest rates that matter most are the lending rates and deposit rates set by banks, the pass-through of policy rates to bank lending and deposit rates is a basic step in monetary policy transmission.

In addition to the transmission via interest rates, there are amplification mechanisms that work via the cost, the availability, and the quality of credit and that are able to generate relatively large real effects even with relatively small monetary policy changes. The main amplification mechanisms operating via banks are the balance sheet channel, the bank lending channel and the risk-taking channel.

The balance-sheet channel of monetary policy predicts that a policy rate hike tends to compress asset prices and weaken activity, thus lowering the net worth of borrowers.^[3] This translates into a reduced capacity to raise external funding for firms: the increase in the external finance premium faced by borrowers due to a decline in net worth and pledged collateral decreases spending and investment by more than what is predicted by a short-term policy rate change in a framework abstracting from the balance sheet channel. The same channel also affects households whose net worth is closely linked to house prices. The lower value of collateral during a policy tightening therefore triggers higher credit risk and tighter credit conditions for both firms and households.

The bank-lending channel focuses on the impact of policy tightening on the supply of bank loans to the economy. First, the supply of loans offered by banks is adversely affected by monetary policy tightening via an increase in bank funding costs.^[4] Second, borrower-lender agency costs further reduce the willingness of banks to lend during periods of higher monetary policy rates or lower economic activity.^[5] Third, bank balance sheet constraints amplify the contraction in credit availability brought about by policy tightening.^[6] Broadly speaking, higher interest rates increase the opportunity cost of holding the most liquid assets – overnight deposits – compared with less liquid assets such as term deposits or securities. Moreover, the unwinding of asset purchases and long-term refinancing operations currently lead to a direct decline in the liquidity available to banks, limiting their capacity to supply credit.^[7]

The third amplification mechanism is the risk-taking channel of monetary policy.^[8] This is the channel through which banks are incentivised to make riskier investments in an environment of lower interest rates, which reduces incentives to engage in costly monitoring.^[9] In addition, asset purchases programmes extract duration risk from the market, increasing the relative attractiveness of riskier investments and therefore triggering a portfolio rebalancing that ultimately leads to a reallocation towards real investments.^[10] As such, during the period of highly accommodative monetary policy, this may have led banks to build up a stock of risky investments. The opposite dynamic may not be operating, as declining risk tolerance can lead to a contraction in the supply of credit.^[11]

Each of the components of the banking channel can interact with each other and generate self-reinforcing mechanisms that further amplify the impact of the initial policy impulse on credit conditions. For instance, following a monetary policy tightening, decreased bank risk tolerance coupled with weaker borrower net worth may affect bank profitability and capital and therefore amplify supply constraints via the bank lending channel. Moreover, general equilibrium effects also interact with the bank lending channel. Strong economic conditions can provide countervailing factors that attenuate the impact of monetary policy, while weak macroeconomic conditions may amplify the strength of monetary policy tightening.^[12] In particular, as aggregate demand falls in response to higher interest rates, banks face both lower demand for loans and a deterioration in borrower credit risk which further weigh on bank balance sheets. These additional factors may further strengthen the bank lending channel of monetary policy.

This brief review of the role of banks in monetary policy transmission has highlighted that the balance sheet channel, the bank lending channel, and the risk-taking channel may be relevant in the transmission of the current hiking cycle. In addition, amongst other mechanisms, the rise in bank funding costs and the drop in liquidity may lead to a contraction in credit supply, adversely affecting bank-dependent firms and households. Next, I will review the incoming evidence on the strength of monetary policy transmission via the banking system during the current tightening cycle.

Measuring the banking channel of monetary policy tightening

Against the backdrop of the tightening of monetary policy, the pass-through to bank funding costs has proceeded rapidly, most notably for yields on bank bonds (Chart 1).^[13] Deposit rates contained the rise in the interest rate expenses of banks during the initial phase of the tightening cycle. This initial sluggishness was in part driven by an atypical configuration of interest rates during the negative rates period, in which many banks kept deposit rates higher than the policy rate (Chart 2, right panel). After this initial period, interest rates on term deposits have followed the policy rate, while the remuneration of overnight deposits has remained lower. Overall, these patterns were also seen in past periods of positive interest rates (Chart 2, left panel).

The limited increase in overnight deposit rates has incentivised depositors to rebalance their portfolios towards time deposits, after the prolonged period of low interest rates and low term premia in which the opportunity cost of holding overnight deposit had been negligible. Comparing developments in the euro area and the United States, while the pass-through to overnight deposit rates is limited in both jurisdictions, the transmission to time deposits has been considerably stronger in the euro area (Chart 2).^[14]

In addition to the increases in the key policy interest rates, the gradual unwinding of the asset purchase programme (APP) and the phase-out of targeted longer-term refinancing operations (TLTRO III) have also played a role in the transmission of monetary policy through banks.^[15] In February this year, we moved to partial reinvestments under the APP before fully ending reinvestments in July. The ensuing decline in bonds held by the Eurosystem reduces the amount of duration extraction associated with the outstanding bond portfolio, and thereby increases term premia. The resulting increase in long-term interest rates pushes up the pricing of bank loans, ultimately increasing lending rates for firms and households. In addition, the higher yields on bonds increase their attractiveness as an investment for banks, reducing their incentives to supply loans.

The phase out of TLTRO III has led banks to partially substitute TLTRO loans with more expensive sources of funding. While a large share of the voluntary early repayments at the end of last year and early this year was financed out of outstanding excess liquidity, banks have been more recently raising alternative funding to cover maturing TLTRO loans, in particular in light of the large amount which matured in June. The need to replace TLTRO funding requires the issuance of more costly bonds and leads to greater competition in deposit markets to attract funding. Furthermore, the recalibration of TLTRO in October 2022 increased the cost of TLTRO borrowing, and restored incentives for voluntary early repayments. The resulting increase in bank funding costs put upward pressure on lending rates and downward pressure on credit supply.

Moreover, the winding down of both the TLTROs and the asset purchases has contributed to a rapid reduction in the central bank excess liquidity available to banks. The combined effect of this outright reduction in liquidity adds downward pressure on the supply of credit by banks, as already evident in survey data (Chart 3). In contrast to the expansion phase, banks now report that the ECB monetary policy asset portfolio and the TLTRO III programme are associated with lower expected lending volumes, as well as tighter expected credit standards and more restrictive terms and conditions.

Turning to the lending rates for firms, the pass-through of tighter monetary policy to overall financing conditions has been strong. Higher bank funding costs translated into a strong increase in lending rates to non-financial corporations, although spreads relative to risk-free rates were somewhat compressed. Lending rates started to increase in June 2022 ahead of the first ECB rate hike. Compared with past hiking cycles, the current campaign has seen the most prominent lending rate increase in the euro area – in terms of both speed and magnitude, also reflecting the unprecedented speed and magnitude of policy rate increases (Chart 4).

At the same time, loan volumes in the euro area have weakened sharply starting from the end of 2022. Credit flows have remained stagnant on aggregate for loans and bonds, with some substitution between the two sources of financing (Chart 5, left panel). The weakening in credit has been stronger than in past hiking cycles and, while this is partly driven by the unprecedented pace of policy tightening, a model-based simulation confirms that loan volumes turned around faster than what would have been expected based on historical regularities, given the path of monetary policy hikes since December 2021 (Chart 5, right panel).