The Bank Lending Channel with Endogenous Money - A Simple Macro Model

Spahn, Peter Article The Bank Lending Channel with Endogenous Money - A Simple Macro Model Credit and Capital Markets – Kredit und Kapital Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Spahn, Peter (2015) : The Bank Lending Channel with Endogenous Money - A Simple Macro Model, Credit and Capital Markets – Kredit und Kapital, ISSN 2199-1235, Duncker & Humblot, Berlin, Vol. 48, Iss. 4, pp. 567-595, https://doi.org/10.3790/ccm.48.4.567 This Version is available at: https://hdl.handle.net/10419/293768 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Credit and Capital Markets 4 / 2015 The Bank Lending Channel with Endogenous Money − A Simple Macro Model Peter Spahn1* Abstract The growth and deepening of financial markets entailed the expectation that the bank lending channel of monetary policy transmission would lose its importance. The paper explains why, on the contrary, the banking sector has become a major locus of origination and amplification of macro-financial shocks. Mutual feedback mechanisms between the financial and the real sector are analysed and simulated by using a simple standard macro model with an integrated banking system. A comparison of the efficiency of various Taylor Rule extensions explores whether monetary stabilisation can be improved by additional interest rate reactions to asset prices, bank lending, bank leverage or the spread between the loan and the policy rate. Der Bankkreditkanal bei endogener Geldmenge − Ein einfaches Makromodel Zusammenfassung Wachstum und Vertiefung der Finanzmärkte ließen vermuten, dass der Bankkreditkanal der geldpolitischen Transmission an Bedeutung verlieren würde. Der Beitrag erklärt, aus welchen Gründen jedoch der Banksektor gesamtwirtschaftliche Störungen verstärkt oder sogar verursacht hat. Wechselseitige Rückwirkungseffekte zwischen dem finanziellen und dem realen Sektor der Volkswirtschaft werden anhand eines einfachen Makromodells mit integriertem Banksektor analysiert und simuliert. Vor diesem Hintergrund wird geprüft, ob die monetäre Stabilitätspolitik durch alternative Erweiterungen der Taylor-Regel verbessert werden kann: insbesondere durch zinspolitische Reaktionen auf Vermögenspreise, * Prof. Dr. Peter Spahn, University of Hohenheim (520A), 70593 Stuttgart, Germany, peter[email protected]. Helpful comments by Felix Geiger, Niels Geiger, Arash Molavi, Lukas Scheffknecht, Benjamin Schmidt, Philipp Schröder, Johannes Schwarzer and an anonymous referee are gratefully acknowledged without implicating them for any of the shortcomings of this paper. Credit and Capital Markets, 48. Jahrgang, Heft 4, Seiten 567–595 Abhandlungen OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 568 Peter Spahn Credit and Capital Markets 4 / 2015 Volumen der Bankkredite, Bankverschuldungsgrad oder den Spread zwischen Kredit- und Geldmarktzins. Keywords: Monetary policy transmission, credit market, leverage targeting, risktaking channel, asset market shocks. JEL Classification: E1, E5, G2 I. Introduction The awakened interest in the macroeconomic role of the banking sector serves the purpose to gain a better understanding of the mutual feedback mechanisms between the financial and the real sector of the economy, and to explore the operating principles of possible policy tools that might be suitable for stabilisation of goods and asset markets. A widely shared impression is that the banking sector tends to aggravate macroeconomic shocks that emanate in non-financial sectors, but apart from this multiplier effect, also produces disturbances with substantial spill-over to goods market. The debate on how to merge the financial sector and the goods market in macroeconomic theory is compounded by the analytical complexity of integrated macro-financial models. The dominating New Keynesian approach requires to build all macroeconomic relationships directly on microeconomic decisions. Critics complain the computational effort necessary to bring together the market behaviour of agents from labour, goods and financial markets if every step ought to be derived from the famous ‘first principles’ of micro foundation; Gertler / Kiyotaki (2010), e. g., give an example. Others express a basic distrust of this ‘fashionable’ modern macroeconomic theory: adding just some financial frictions would not repair the shortcomings of a basically non-monetary model (Borio (2012)). However, it is not necessary to take a stand in this fundamental debate on the adequacy of microfoundation in macroeconomics before being able to grasp the analytical essence of the macroeconomic implications of bank behaviour. There are a couple of papers, among them Woodford (2010) and Friedman (2013), that give a compact treatment of the key relationships. Both focus on the role of the interest rate spread between the money and the credit market and explore potentially destabilising effects of financial intermediation. Other contributions, e. g. Adrian / Shin (2010) and Disyatat (2010), offer a more detailed image of banking sector operations, but from a more partial-market analysis perspective. The current paper takes up these threads, but aims to maintain a general-equilibrium OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 The Bank Lending Channel with Endogenous Money 569 Credit and Capital Markets 4 / 2015 view and uses a middle-way degree of algebra that is able to yield similar insights and results as more formal treatments as, e. g., Gerali etal. (2010) or Gambacorta / Signoretti (2013). After all, it is the respect scientists should pay to the principle of Occam’s Razor that justifies the defence of ‘small models’ (Krugman (2000)). A main motivation of the current paper is the aim to develop a medium-scale approach with a limited amount of readily comprehensible algebra. It presents a kind of a workhorse model that can be extended and applied to many related questions; yet it lacks however an empirically realistic calibration of the functional parameters so that policy-relevant conclusions should be taken with care. The program of the paper is as follows: Section II presents some stages of the debate on the bank lending channel since the 1980s. This has been a period of rapid growth and deepening of financial markets. But, much to the contrary of what the traditional view on monetary policy transmission via bank credits would make believe1, the message is that bank activities on both sides of their balance sheets gain in their importance for the macroeconomy if banks are embedded in a well developed financial market. Section III, starting from a simple optimisation calculus, derives lending and funding decisions of an integrated banking sector, which then is included in a standard modern macro model where the non-bank sector acquires funds exclusively via the credit market. Section IV uses the model to explore the consequences of different shocks. First, it is demonstrated that autonomous asset price movements are able to produce credit market reactions and thus macroeconomic effects much the same as discretionary interest rate decisions on the part of the central bank. Second, the focus is on a beneficial supply shock that is amplified by reactions of the banking sector (including the central bank) and thus may lead to an overheating of goods and credit markets. Third, the comparison of alternative policy options in addition to the Taylor Rule yields some arguments in favour of specific interest rate reactions to the spread between credit market and money market rates, to asset prices, or to the volume of bank lending. Section V concludes with a short summary. 1 “Bank lending channels were likely to have been more important during periods in which financial markets were more heavily regulated. […] In an environment in which interest rates are free to adjust, the bank lending channel of monetary policy is likely to be of lesser importance” (Walsh (2003), p. 345). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 570 Peter Spahn Credit and Capital Markets 4 / 2015 II. Old and New Aspects of the Credit View 1. Availability-of-Deposits Doctrine and Central Bank Money Supply Banks’ balance sheets have expanded rather steadily, relative to nominal GDP, since the end of the Second World War, though with a pronounced peak of that ratio in the recent decade, but the scientific assessment of the banks’ importance for macroeconomic activity took place in a few distinctive steps. The Keynesian Revolution had pushed the credit market, which occupied a prominent position in pre-Keynesian macroeconomic thinking (Trautwein (2000)), almost into oblivion, following a new modelling architecture, suggested in Keynes’s General Theory, that focused on the money market instead. Until the early 1980s, the Money View prevailed where bonds and bank loans were treated as perfect substitutes. The convenient conclusion was that the dynamics of macroeconomic activity and the concepts of monetary stabilisation could be analysed without an explicit need to integrate the behaviour of financial intermediaries (Freixas / Rochet (2008), p. 195). Building on Bernanke’s (1983) work on the Great Depression, the newly developing Credit View took account of market imperfections, mainly arising from asymmetric information. The message was twofold: it became obvious that a large part of prospective debtors had no access to the capital market, which established a kind of market segmentation between bond financing and demanding bank loans; banks provision against the implications of adverse incentives on the part of their debtors, which explains the use of collateral as an additional constraint of bank lending (Gertler (1988), Bernanke / Gertler (1995)). Monetary policy transmission thus had to be considered in a somewhat richer framework. The bank lending channel was added to the interest rate channel. However, as central banks still basically were assumed to operate by way of a quantitative reserve management (this was the legacy of the IS-LM model), and commercial-bank deposits were regarded as the key source of bank funding and initiating factor of bank lending, the assumption of a stable multiplier relationship between high-powered money and bank deposits promised a reliable control of overall banking activity. Open-market sales of government securities on part of the central bank, e. g., would deprive commercial banks of a proportional amount of deposits and thus would compel a reduction of bank lending (Bernanke / Blinder (1988)). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 The Bank Lending Channel with Endogenous Money 571 Credit and Capital Markets 4 / 2015 The availability-of-deposits doctrine is still accepted in the circle of central banks2 although it appears flawed. First, interest rate elasticity of transaction balances is low, and bank accounts nowadays are remunerated near to market rates so that the incentive to modify portfolios is weak. But the key argument is that the doctrine suffers from a fallacy of composition: “For the system as a whole, deposits cannot fall unless banks issue new liabilities to replace them or sell an asset to non-banks (including loan repayment). Individual agents’ attempt to dispose of their deposit holdings by buying assets from other non-bank private sector agents simply redistributes deposits within the system leaving aggregate deposits unchanged” (Disyatat (2010), p. 7). This does not mean that nonbanks are forced to keep a portfolio of money wealth that is not aligned with their preferences; but if bank clients switch from low-yield deposits to higher-yield savings accounts or bank-issued securities, the volume of bank funding still is unchanged (although there is a cost effect of funding to be discussed below). The credit channel of monetary policy transmission has a misplaced emphasis on the availability-of-deposits doctrine. A second fundamental objection challenges the associated popular, though mistakable, view that deposits determine bank loans. The dispute on whether ‘deposits make loans’ or ‘loans make deposits’ has a long history.3 With regard to this topic, there is also a rarely mentioned ‘cultural’ distinction between American and European monetary theory. Students of US textbooks learn that “banks make profits by selling liabilities with one set of characteristics (a particular combination of liquidity, risk, size, and return) and using the proceeds to buy assets with different characteristics”, in short, they practise a kind of asset transformation from saving deposits into loans, i. e. they lend out money previously collected (Mishkin / Eakins (2006), p. 429). British textbooks, on the other hand, stress that for “every loan created, someone must receive an addition to his or her deposit” (Howells / Bain (2005), p. 236) and demonstrate that the extension of bank 2 “Bank lending tends to contract after a tightening in monetary policy because an increase in the policy rate is usually followed by a reduction in the availability of bank deposits as deposit holders shift their investments from deposits towards assets offering a higher return. Unless banks can compensate for the decline in deposits via other sources of funding, the downward adjustment acts as a constraint on the asset side of banks’ balance sheets, ultimately inducing a contraction in bank loans” (ECB (2010a), p. 63). 3 It has close connections with the debate on the causality of saving over investment, or vice versa, and thus formed a key topic in the controversy between neoclassical and (post) Keynesian economics (Lavoie (1984)). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 572 Peter Spahn Credit and Capital Markets 4 / 2015 credit necessarily goes along with a lengthening of bank balance sheets. Recently, the Bank of England emphasised this principle of endogenous creation of bank money in a much-noticed contribution (McLeay etal. (2014)). The controversy has an important implication for the understanding of the relationship between banks and financial markets. According to the American view, both institutions deliver basically an equivalent service of intermediation where banks increase the length and efficiency of transaction chains. This understanding however misses a key point: whereas on financial markets an existing stock of means of payment is transferred between creditors and debtors (in most cases by way of an exchange of bank deposits and newly issued securities), writing credit contracts between banks and new debtors implies the creation of new deposits.4 For profit-maximising reasons the active, ‘primary’, business of banks is granting loans, but at the end of the day balance sheet bookkeeping shows that they appear to be ‘financed’ by deposits (that not necessarily are meant to be ‘savings’). The dominance of the ‘loans make deposits’ business strategy requires that banks rightly expect to obtain additional reserves necessary to cover minimum reserves and cash withdrawals that result from new lending. Also the effect of the above example of a restrictive open-market policy move is not that it draws deposits, but rather that it draws reserves from the commercial banking system; and loan supply might be reduced if banks expect to acquire new reserves only at prohibitive costs. Preserving required liquidity is a key side condition of bank behaviour; the cost effect of non-banks’ attempts to shift away from cheap deposits (that emerge as a by-product of credit creation) can only be countered by resorting to central bank refinancing. Therefore the overriding question is whether the market for reserves shows supply side constraints or not. Here, central bank practice and policy norms have changed over the past decades. In the early days of central banking, quantitative restrictions for the creation of high-powered money were indispensable due to obligations of note convertibility into fixed amounts of precious metal 4 “Capital market intermediation, like barter and commodity money or cashbased systems, requires that the creditor have on hand the means of payment to deliver to the debtor before the credit is extended. […] Bank lending, on the other hand, involves the creation of bank deposits that are themselves the means of payment” (Disyatat (2010), p. 7–8; cf. Borio (2012)). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 The Bank Lending Channel with Endogenous Money 573 Credit and Capital Markets 4 / 2015 (as in the gold standard). During the 20th century, it was difficult to ascertain whether announcements of base money control were meant to indicate a factual use of that policy tool or merely a way of central bank communication with the public; the period of the Bundesbank’s famous strategy of monetary targeting is a case in point (Bindseil (2004), Beyer etal. (2009)). The policy norm in modern times is unambiguous however: central banks endeavour to avoid any reserve shortages because they produce deviations of the money market interest rate from the policy rate; even if only temporary, these deviations appear as technical imperfections of policy making as they distort the signal of interest setting.5 When central bank money is supplied endogenously, both the availability-of-deposits doctrine and the concept of a money multiplier have hardly persuasive power. With regard to bank lending, apart from capital restraints (that also were lowered in recent decades) “there is no quantitative constraint as such. […] While traditional models assume that a monetary tightening leads to a shortage of liquidity for banks, the presumption here is that it leads to a disproportionate rise in the price of funding liquidity, which is readily available” (Disyatat (2010), p. 8–9). Thus, an alternative interpretation of monetary policy effects in the bank lending channel points to price-theoretic arguments. Bernanke and Blinder argued already in 1992 that, even if base money supply is elastic in the short run, higher central bank interest rates will also increase yields paid on deposits. The typical maturity mismatch of bank assets and liabilities then produces a profit squeeze if rate adjustment with respect to the stock of credit is precluded. Then the only expedient − pronounced interest rate increases for new lending − is bound to reduce the volume of credit. A price effect also is felt in the impact of interest rate policy on a prospective debtor’s pledgeable wealth: changes of capital market interest rates inversely modify the value of bank clients’ collateral and thus signal an improved, or worsened, degree of creditworthiness. This balance sheet effect connects the interest rate channel 5 Contrary to the Bundesbank tradition, the ECB propagates a Separation Principle of interest setting on the one hand, expressing the macroeconomic policy stance, and the provision of high-powered money on the other hand, located on the ‘lower’, technical level of facilitating payment flows within the banking system and in the macroeconomy at large (ECB (2010a), Fahr etal. (2011)). For a general survey on the independency of interest rates and monetary aggregates as policy instruments in modern central banking see Disyatat (2008). Friedman (2014) argues that central banks will continue to use both instruments also after the financial crisis. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 574 Peter Spahn Credit and Capital Markets 4 / 2015 and the bank lending channel and magnifies − as ‘financial accelerator’− the impact of monetary policy interventions. 2. Risk-Taking and Credit Supply A more recent step in the growing understanding of the bank lending channel was the realisation that valuation effects also bear on banks’ balance sheets, which then might trigger a change of credit supply. In general, risk taking will increase with rising perceived wealth. Variations in the value of bank assets, either brought about by interest policies or by a new assessment of asset risks, modify bank capital and − if banks aim at keeping a constant leverage ratio (i. e. bank assets relative to equity) − induce the purchase of new assets and / or the writing new credit contracts; often even a procyclical variation of leverage has been found (Adrian / Shin (2010), Nuño / Thomas (2013), Borio (2014)). These credit supply shifts are the key element of the new ‘risk-taking channel’ of monetary policy. It differs from the well-known impact of risk considerations on the part of debtors / investors by focusing on the behaviour of creditors. A market-driven rise of bank capital “increases the risk-taking capacity of the banking system, which in turn leads to a lower equilibrium risk premium, and an increase in the supply of credit by lowering the hurdle rate at which projects are financed” (Adrian / Shin (2010), p. 638). In addition, a successful record of monetary policy in the recent past, high credibility of central banks, a period of low inflation and supply-side innovation, all encourage risk-taking and investment on asset markets (Borio / Lowe (2002), Borio / Zhu (2008)). Active acquisition of assets requires additional funding that in recent decades shifted from attracting deposits to tapping domestic and foreign financial markets.6 A concomitant observation is that bank-issued securities grew large in relation to broad money (Shin / Shin (2011)). The more general finding is that bank activity is underrated by looking at any broad money aggregate; bank assets and bank loans, taken as ratios to 6 In Germany, between 1980 and the early 2000s, the balance sheet share of overall deposits decreased from 50 % to 32 %, while the shares of bond sales and foreign indebtedness rose from 17 % to 24 %, and from 3 % to 10 %, respectively. After the financial crisis however, figures have changed somewhat in direction of earlier values (see Deutsche Bundesbank Homepage, statistical series, nos. BBK01. TUD401, ~430, ~447, ~449). For the US banking sector, a comparison of deposit and non-deposit borrowing growth rates is given by Adrian / Shin (2006). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 The Bank Lending Channel with Endogenous Money 581 Credit and Capital Markets 4 / 2015 ard modelling of goods demand, only the credit-income ratio would change − a not very realistic feature of a banking-macro model. Therefore, in the following a different set-up is preferred for the design of the goods demand function. Besides the difference between the real credit market and the ‘normal’ interest rate, deviations from the steadystate volume of credit L are added as a further driving force; the β × () L term thus also captures the impact of access to finance or, inversely, the relevance of credit rationing (note however that the qualitative results of the model do not depend on β >0 L). Whereas the basic New Keynesian model assumes that market agents operate on a perfect financial market, the extreme alternative here is that banks alone provide financing.13 In general, it is a hybrid version of an otherwise rather standard New Keynesian demand function that contains lagged output besides output expectations in order to capture the large dose of persistence observed in actual data; the corresponding microfoundation refers, e. g., to habit persistence in consumption demand. Equilibrium output is normalised to zero. (10) ( ) ( ) θ θβπ β * +- + æö ÷ ç÷ =- + - - - + - ç÷ ç÷ èø 11 1 11 t LL t y tt y t tt t L y Ey y i E r L Also the supply function shows, for reasons of adjustment and information costs, partly forward looking expectations and partly adaptive behaviour; the literature on agents’ learning behaviour and sticky infor- 13 An intermediate modelling strategy would make use of two interest rates in the goods demand equation as, e. g., in: Cecchetti / Kohler (2012). L r L s L d A B Figure 2: Credit Market Equilibrium Shift After Expansionary Supply and Demand Shocks OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 582 Peter Spahn Credit and Capital Markets 4 / 2015 mation provides impressive evidence of the relevance of lags in key macroeconomic relations. It is complemented by an AR(1) disturbance term π ε t that symbolises inflation shocks with persistence; its formal pattern conforms to eq. (2). (11) ( ) π ππ π θ π θπ α ε +- =- + + + 11 1 t tt t t t Ey Monetary policy is represented by a simple Taylor Rule with a zero inflation target and a possible disturbance term ε i t, again following the pattern of eq. (2). In accordance with broad evidence, a large dose of interest rate smoothing (denoted by θ i) is assumed. The central bank’s equilibrium interest rate * i can be found by solving for the equilibrium values of the model’s variables. The logic of stabilisation requires the central bank to target * r in eq. (10), the rate that maintains goods market equilibrium, by controlling the credit market rate L t i as an intermediate variable. This in turn is achieved via shifting the credit supply function (8) by means of central bank interest rate changes. In equilibrium, * i has to correct * r for the basic credit default risk, for the cost effect of the external finance premium, and for the implications of a difference between targeted and steady-state leverage λ =+ ()A LC . The whole difference ( ** - ri ) constitutes the ‘credit spread’ that figures prominently in present vintages of New Keynesian macroeconomics (Woodford 2010). (12) ( ) ( ) π θ τπ τ θ ε *- =- + + + + 1 1i t i t y t it t i i yi (13) ( ) ρ ψλ δ λ λ ** * = -- + -ir IV. Multiple Market Shocks and Policy Responses 1. Interest and Valuation Shocks The working of the model is now demonstrated by comparing the effects of two disturbances that originate in the financial sector: a discretionary reduction of the central bank interest rate and an exogenous increase of asset prices (Figure 3).14 In both scenarios asset prices are driv- 14 The IRFs show the adjustment path of selected endogenous variables after a one-off change of the chosen exogenous shock variables ε i t and ε f t that however maintain a diminishing part of their impact due to persistence; see eq. (2). For that exercise, a first-order approximation of the model was calculated by the OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 The Bank Lending Channel with Endogenous Money 583 Credit and Capital Markets 4 / 2015 en upwards, either via lower interest rates or via valuation shocks. Loan supply shifts to the right, in the case of a monetary policy move mainly brought about by the lowered Taylor rate, and reflecting a change of asset prices in the second case: the actual leverage ratio falls, which also lowers the cost of external financing, and banks wish to return to the Dynare software so that a linear system of difference equations evolves. The initial shock sign was chosen as negative in the case of an interest rate impulse, and positive in case of asset prices. The size of both shocks was set to 0.01; the persistence of ε f t is 0.7, and 0.1 in case of ε i t, taking into account that the path of interest already entails persistence. Values displayed in the graphs indicate percentage point (leverage: absolute) deviations from steady state. Model parameters were set as follows: ψ =0.001 , *=0.03r, λ *=12, ρ =0.01 , π τ =1.2 , δ =0.005 , η =1 , βτ ==0.3 y, β µσϕ ====0.2 L, αγκ κ == = = =0.1 AL C, π θθ = ==== y ALD π θθ = ==== 0.5 yALD . Figure 3: Impulse Response Functions (IRFs) After Negative Interest Shock (Dashed Line) and Positive Financial Market Valuation Shock (Grey Line) OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 584 Peter Spahn Credit and Capital Markets 4 / 2015 target level by writing more credit contracts. The increase of bank lending, which is largely financed via bond sales, lets the real loan rate drop so that goods demand expands. Note that, in the monetary policy shock scenario, the first period’s value of the central bank interest rate reflects the discretionary easing impulse as well as the rule-bound increase of the Taylor rate, although cushioned by the practice of interest rate smoothing. The graphs show that the short-term policy rate affects the macroeconomy not only by means of its influence on the costs of bank refinancing; movements of t i have a grip on the loan rate and thus the interest spread, i. e. bank profits.15 Via its influence on the loan rate, t i also triggers wealth effects on the part of creditors and debtors, shifting both credit market functions. Asset market sentiments perform a transmission mechanism on their own, in their effect similar to monetary policy actions. In the model, the movement of t A exhibits high correlation with the real interest rate and output (−0.87 and 0.84, respectively). The impulse response functions reveal that the central bank is forced to lean strongly against the expansionary impulse originating from the valuation shock, just to prevent an even more pronounced output growth. A negative valuation shock would produce a scenario of deleveraging where a downgrading of asset prices forces banks to adjust their asset holding in a downward direction in order to restore their leverage target (imagine an inversed course of the grey IRFs in Figure 3). This includes a restriction of credit supply. Demand and production shrink on the goods market, and stabilisation requires a lower Taylor interest rate (Leijonhufvud (2009), Borio (2014b)).16 2. The Case of a Beneficial Supply Shock Whereas in previous decades macroeconomic stability often was endangered by inflation shocks that posed a severe trade-off with regard to the 15 “At each stage of the intermediation chain, the funding interest rate must be lower than the asset interest rate. As the intermediation chain becomes longer, more short-term funding must be used to support the chain, as short-term funding tends to be the cheapest” (Shin / Shin (2011), p. 14). 16 The model is not designed for an adequate analysis of this kind of balance sheet recession because it ignores the zero lower bound of nominal interest rates and the practice of selling capital market assets on a large scale. Such a ‘fire sale’ in times of liquidity stress contributes to a further fall of asset prices and requires non-banks or the monetary authority to act as buyers, but this issue is not further explored in this paper. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 The Bank Lending Channel with Endogenous Money 585 Credit and Capital Markets 4 / 2015 employment issue, a more recent topic is the somewhat paradoxical scenario where an economy suffers in the end from a − taken by itself − beneficial event like, e. g., the discovery of a new technology, because an overly elastic credit system misleads markets onto a bubble path that is bound to crash later. Therefore the model attempts to confirm various findings in the literature saying that a ‘leaning against the wind’ on the part of the central bank in times of good-news driven credit booms might help to prevent bubbles (Christiano etal. (2008), De Grauwe / Gros (2009), Gambacorta / Signoretti (2013)). This scenario can be reproduced in the above model by following the various implications of a cost-diminishing AR(1) supply shock π ε t in eq. (11). 17 In order to refer to the different stages of the bank lending channel discussion, three model variants are distinguished: (1) The basic case uses only stripped-down versions of the credit market equations where collateral effects on the part of debtors, and leverage effects on the part of creditors are ignored, i. e. κϕ == 0 L in eq. (9) and κσ == 0 A in eq. (1). The simulation of the model’s key variables is drawn in solid black lines (Figure 4). The whole process shows a relatively moderate expansion. Note that the figures of period 1 capture only the net effect of a complicated pattern of interaction. The initial lowering of inflation call for a Taylor rate response that triggers a credit supply shift, and thus a goods market expansion. (2) The second scenario describes the financial-accelerator effect that originates from an endogenous increase of debtors’ wealth. Higher expected income and lower interest rates let the value of collateral grow; ϕ > 0 and κ > 0 L in eq. (9). The immediate result is a right-shift of the credit demand function (Figure 2); the impulse response functions of lending (L) and the loan rate ( L i ) accordingly both start from a higher value (dashed lines in Figure 4). (3) Finally also some new features of the bank lending channel are taken into account. The value of bank assets changes with lower interest rates and higher output; κ >0 A and σ >0 in eq. (1). Concomitant capital gains reduce the actual leverage ratio and thus induce further lending in order to meet the leverage target. The credit supply function shifts to the right (Figure 2), thereby further increasing the volume of loans. Initially this lowers the loan rate, but the stabilising increase of the central bank interest rate acts as a countervailing power during the adjustment process. Output expansion is strongest (grey lines in Figure 4). 17 The size of the π ε t shock is 0.01 with 0.7 persistence. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 586 Peter Spahn Credit and Capital Markets 4 / 2015 The credit market spread ( - Lt t ii ) is a complex variable, driven by the behaviour on both sides of the credit market, by policy, expectations and shocks. From a macroeconomic point of view, it is like a ‘tax on intermediation’ (Woodford (2010)), at the same time indicating the risk and profitability of bank activity (Adrian / Shin (2010)). In all three cases of the model simulation, monetary policy aims to stabilise inflation and output gaps, a task that is impeded by the only indirect (and less than proportional) transmission of the policy rate to the relevant credit market interest rate via the shift of the credit supply function. But money market and Figure 4: IRFs After Inflation-diminishing Shock in Three Variants of the Bank Lending Channel: Basic Version Without Financial Accelerators (Solid Black Lines), Inclusion of Interest-rate-induced Wealth and Income Effects on the Part of Debtors (Dashed Black Lines), Additional Inclusion of Interest Rate and Income Effects on Creditors Assets Values (Grey Lines) OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 The Bank Lending Channel with Endogenous Money 587 Credit and Capital Markets 4 / 2015 credit market rates always move in the same direction (although their correlation is weakened due to the central bank’s interest rate smoothing), whereby the interest rate spread is compressed. The spread shows a strong negative correlation with output (−0.92, −0.89 and −0.94, respectively). 3. Alternative Policy Options This opens the discussion on possible policy strategies beyond the simple Taylor Rule in both above scenarios of a positive asset price shock and a beneficial supply side shock.18 In order to complete the picture, background calculations on three further shocks are also taken into account: a goods demand shock, an exogenous lowering of credit default risk, and an increase of the ‘natural’ rate of interest.19 With regard to policy options, six extensions of the simple Taylor Rule can be distinguished: (1) Following Woodford’s recommendation, a term τ - () L St t ii might be added to the Taylor Rule, i. e. inserted into the second bracket of eq. (12). This prescription establishes a negative reaction to the loan rate, and it indirectly augments the weight of inflation and output gap coefficients as long as τθ - <- 1 (1 ) Si , as can be seen by solving eq. (12) for the central bank rate. Hence, this strategy indirectly supports the case for strengthening the commitment to (flexible) inflation targeting. (2) Alternatively, an additional interest rate response to the movement of asset prices of the form τ -( 1) At AA can be considered as they act as amplifiers in the bank lending channel (Gambacorta / Signoretti (2013)).20 (3) The perhaps more obvious policy is to target ‘excessive’ lending growth, which is simulated in the model by a Taylor Rule add-on τ -( 1) Lt LL . Such a reform can be proposed on account of the impres- 18 Note that due to the lacking empirical specification of model parameters the following is to be understood as a theoretical exercise, completing the analytical discussion of the model; it offers only a sketchy contribution to the literature on optimal policy making (see, e. g., De Fiore and Tristani 2012). 19 Also these disturbances were modelled as AR(1) processes with 0.01 size and 0.7 persistence. 20 An earlier debate on the question of including asset price stability in the central bank’s objective built on the welfare-theoretic argument of a substitutive relationship between goods as assets, and stated that goods market inflation alone is a poor indicator of the value of money. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 588 Peter Spahn Credit and Capital Markets 4 / 2015 sive macroeconomic power of bank credits, but also if credits are regarded as the counterparty item to a broad monetary aggregate, i. e. by modifying the traditional monetarist concept of policy making.21 (4) The balance-sheet-counterpart approach is to include an external-finance target of the form τ -( 1) Bt BB in the Taylor Rule. It is a possible policy instrument that can be activated in order to constrain negative systemic risk externalities that might result from excessive short-term funding.22 Goodhart (2010) therefore once simply suggested a tax on banking. (5) Considering the prominent role of the leverage ratio, an obvious idea is to control its level by modifying the effect of the external finance premium t f . This can be achieved by adding a term λ τλ t to the Taylor rate. (6) Finally macroprudential regulation can impose maximum prescriptions for the banks’ leverage target, a measure suitable to constrain the growth of bank balance sheets, and of lending in particular (reducing λ * shifts the credit supply function upwards). The choice of λ * however has only an impact on the equilibrium position of the credit supply curve and therefore is reflected in the determination of the equilibrium central bank interest rate * i in eq. (13), but it has no bearing on shock adjustment paths. Hence, alternative policies (1) to (5) can be evaluated by minimising the simple loss function π Ω =+ 22 t tt y. For each of the coefficients τ S, τ A, τ L, τ B and λ τ an optimal value was calculated in a setting where all five shocks (asset prices, supply side, goods demand, credit default, ‘natural’ rate) occur at the same time. This setup was chosen because the nature of macroeconomic disturbances often cannot easily be understood or distinguished by the policymaker; thus it makes sense to ask for a policy strategy that works best under all circumstances. The results23 show that Taylor Rule extensions indeed yield lower welfare losses compared to the baseline policy (Table 2). A somewhat irritat- 21 “The observation that credit growth is high in booms suggests that if credit growth is added to interest rate targeting rules, the resulting modified rule would moderate volatility in the real economy and in asset prices” (Christiano et al. (2010), p. 23; cf. ECB (2010b)). 22 “The bank lending channel works through the impact of monetary policy on banks’ external finance premium as determined by their perceived balance sheet strength” (Disyatat (2010), p. 8; cf. Shin / Shin (2011), Perotti / Suarez (2011)). 23 They were calculated by using Dynare’s Optimal Simple Rule software procedure. A potential drawback of the algorithm is that it delivers local, but not OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 The Bank Lending Channel with Endogenous Money 589 Credit and Capital Markets 4 / 2015 ing finding is that the optimal λ τ parameter is negative. The reason is that effective leverage initially is below the banks’ target level in all cases where positive market or policy impulses impinge on bank assets and capital; this in turn motivates the acquisition of additional assets. Therefore, a monetary policy that responds to low (high) leverage with low (high) interest rates runs the risk of producing pro-cyclical effects. In general, an interest rate response to the credit market spread promises to deliver good results. This finding also followed from Woodford’s non-for- mal analysis and motivated him to suggest “that changes in credit spreads should be an important indicator in setting the federal funds rate; the funds rate target should be lower than would otherwise be chosen, given other conditions, when credit spreads are larger” (2010, p. 39). With regard to the traditional monetary policy trade-off between output and inflation stabilisation, financial frictions produced and managed by a banking sector call for a modification of policy rules (Davis / Huang (2013)). Focusing the beneficial-supply-shock scenario, Gambacorta and Signoretti (2013) find that employing an extended Taylor Rule that reacts to assets prices (strategy τ A) improves the trade-off on the frontier of innecessarily global optima. This poses hardly a problem in the present context. The iterations in all cases start at the zero value of the additional instruments. This also marks the institutional status quo. Economic policy reforms mostly come in gradual steps. Therefore very large values, even if they would allow the movement to a global optimum, are not that relevant. Moreover, case by case runs by using larger starting values did not yield different results. Table 2 Loss Levels of Alternative Policy Strategies Results Policy Optimal instrument value Loss level Simple Taylor Rule 6.35 Additional response to – spread τ =1.18 S1.24 – asset prices 1.10 1.74 – lending τ =1.20 L2.24 – external finance τ =0.32 B5.59 – leverage 0.006 λ τ =- 3.62 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26 590 Peter Spahn Credit and Capital Markets 4 / 2015 flation and output variability.24 This result is not confirmed by the above model, as other policies, particularly a control on lending, provide better results (Figure 5). Also De Grauwe / Gros (2009) propose a monetary tightening in the above case of a beneficial supply shock, but focus on measures constraining bank liquidity as, e. g., higher minimum reserve requirements. This appears to be a reasonable idea, particularly because weaker liquidity constraints “can support higher risk-taking. […] The link between liquidity and risk-taking can add to the strength of the monetary policy transmission mechanism − a sort of ‘liquidity multiplier’” (Borio / Zhu (2008), p. 12). Unfortunately, in an institutional setting where banks’ base money demand is always met without quantity constraints (and where interest payments are granted on minimum reserves) the proposal hardly makes any sense. Blocking the quantitatively unlimited access to central bank finance (the flexible use of the variable t B in the model) would indicate a major institutional U-turn in the banking industry. Such a reform would substantially shrink the manoeuvring room for bank business on both sides of their balance sheets. For any single bank, the provision of liquidity 24 This frontier is called the Taylor Curve and the graphs show equilibrium positions that can be chosen by the policymaker. Thus there is an exploitable tradeoff between inflation and output variability (Taylor (1994)), in contrast to the notrade-off message of the standard Phillips Curve. Figure 5: Taylor Curves in Beneficial-supply-shock Scenario, Taylor Output Gap Coefficient ν τ Increasing in 0.1 Steps from Right to Left (While π τ Held Constant) OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.48.4.567 | Generated on 2023-01-16 13:25:26