KONSTANTĪNS BEŅKOVSKIS IS THERE A BANK LENDING CHANNEL OF MONETARY POLICY IN LATVIA? EVIDENCE FROM BANK LEVEL DATA - PDF

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ISBN X KONSTANTĪNS BEŅKOVSKIS IS THERE A BANK LENDING CHANNEL OF MONETARY POLICY IN LATVIA? EVIDENCE FROM BANK LEVEL DATA 2008 WORKING PAPER Lavias Banka, 2008 This source is o be indicaed

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ISBN X KONSTANTĪNS BEŅKOVSKIS IS THERE A BANK LENDING CHANNEL OF MONETARY POLICY IN LATVIA? EVIDENCE FROM BANK LEVEL DATA 2008 WORKING PAPER Lavias Banka, 2008 This source is o be indicaed when reproduced. CONTENTS Absrac 2 Inroducion 3. The Bank Lending Channel 4. Ineres Rae and Credi Channels: a Brief Overview of Theoreical Conceps 4.2 Deerminans of he Bank Lending Channel 6 2. A Shor Descripion of Lavia's Banking Secor 7 2. Imporance of he Banking Secor for Lavia's Financial Sysem Srucure of Lavia's Banking Secor 8 3. Discovering Asymmeries in Bank Lending Behaviour 2 3. A Brief Overview of Previous Empirical Sudies Panel Approach o Idenifying Asymmeries in Bank Lending Esimaion Mehod 6 4. Bank Lending Channel in Lavia: Economeric Esimaions and Resuls 7 4. Daa Issues Bank Loans o Residens Bank Loans o Households and Non-Financial Corporaions Robusness Check Alernaive Specificaions Robusness of he Resuls for Differen Time Periods 30 Conclusion 3 Appendices 33 Bibliography 43 ABBREVIATIONS CPI Consumer Price Index CSB Cenral Saisical Bureau of Lavia ECB European Cenral Bank EURIBOR 3M Euro Inerbank Offered Rae, he index of European inerbank euro credi ineres raes for credis wih a 3-monh mauriy FCMC Financial and Capial Marke Commission GDP Gross Domesic Produc GMM Generalised Mehod of Momens HHI Herfindhal-Hirschman Index LCD Lavian Cenral Deposiory LIBOR SDR 3M he index of SDR ineres raes for credis wih a 3-monh mauriy, calculaed using London Inerbank Offered Rae Indices MFI moneary financial insiuion. Credi insiuions and oher financial corporaions whose business is o receive deposis and/or close subsiues for deposis from eniies oher han MFIs and o gran credi and/or make invesmen in securiies for heir own accoun, as well as naional cenral banks. RIGIBOR 3M Riga Inerbank Offered Rae, he index of Lavian inerbank las credi ineres raes for credis wih a 3-monh mauriy SDR Special Drawing Righs ABSTRACT The goal of his paper is o explore he role of he banking secor in ransmission of he Bank of Lavia's moneary policy and o check he exisence of he bank lending channel in Lavia. For empirical invesigaion of he bank lending channel in Lavia, we use he approach ha builds on he sandard panel regression. The evidence on he bank lending channel is obained by esimaing a bank loan funcion ha akes ino accoun no only he moneary policy indicaor and macroeconomic variables, bu also bank-specific differences in he lending reacion o moneary policy acions. Empirical analysis shows ha some banks in Lavia have saisically significan negaive reacion o a domesic moneary shock; however, he weighed average reacion of he oal las loan growh is no saisically significan. A domesic moneary shock has only a disribuion effec and affecs banks ha are small, domesically owned and have lower liquidiy or capialisaion. The bank lending channel is limied only for he supply of las loans, which dramaically reduces he imporance of his channel. Keywords: moneary policy ransmission, bank lending channel. JEL classificaion: C23, E52, G2 The views expressed in his publicaion are hose of he auhor and do no necessarily represen he official views of he Bank of Lavia. The auhor assumes responsibiliy for any errors or omissions. The auhor wans o hank Mārcis Risbergs (Bank of Lavia for his assisance in daabase creaion, and Vikors Aevskis, Zoa Razmusa, Jeļena Zubkova (Bank of Lavia and Velga Vilne (Financial and Capial Marke Commission for heir valuable commens and recommendaions. 2 INTRODUCTION The analysis of he moneary policy ransmission, i.e. how moneary policy changes affec he real economy, is one of he mos researched areas in macroeconomic lieraure and a special focus for cenral bankers. Recen heoreical and empirical findings enlighen, sep by sep, he ransmission process of moneary policy. According o he radiional ineres rae channel, a change in policy-induced ineres raes influences he real economy by affecing various relaive prices. A higher cos of capial increases he reurns required for an invesmen proec and, herefore, diminishes invesmen expendiures. Changes in ineres raes also affec consumpion, as higher ineres raes decrease he price of fuure consumpion. In he case of a flexible exchange rae regime, ineres rae movemens affec he nominal exchange rae, price compeiiveness and hence also ne expors. However, he ineres rae channel heory ignores some imporan processes in he banking secor. The credi channel view acknowledges he exisence of informaional imperfecions in financial markes and assigns an acive role o he supply of bank loans in moneary ransmission via wo subchannels he balance shee channel, which saes ha igh moneary policy may worsen borrowers' risk characerisics and reduce he supply of loans, and he bank lending channel, which saes ha he cenral bank policy can affec bank balance shees and hence also he supply of loans. The laer, i.e. he bank lending channel, is of especial ineres for us in his paper, as i focuses more specifically on he paricular role of banks in he ransmission mechanism. The exisence of he bank lending channel has a very imporan implicaion for moneary policy: he ransmission process of moneary policy depends on he srucure of he financial sysem. This means ha srucural changes in financial area may affec moneary ransmission. Moreover, moneary policy can also have a disribuion effec, as individual banks wih differen specific (or individual characerisics will have an asymmeric reacion o moneary shock. The goal of his paper is o explore he role of he banking secor in ransmission of he Bank of Lavia's moneary policy and o check he exisence of he bank lending channel in Lavia. For his purpose, we use microeconomic daa ha help o solve he idenificaion problem of loan supply effec versus loan demand effec of moneary policy. The approach used in he paper builds on currenly very widely acceped sandard panel regression mehodology. Evidence on he bank lending channel is obained by esimaing a bank loan funcion using daa of individual banks. This funcion akes ino accoun no only he moneary policy indicaor and macroeconomic variables bu also bank-specific differences in lending reacion o moneary policy acions. The main quesion is wheher here are cerain ypes of banks ha show a relaively srong decrease in lending afer moneary ighening. The srucure of he paper is as follows. Secion provides a brief heoreical overview of moneary ransmission channels wih a special focus on he bank lending channel. The main feaures of Lavia's banking secor are described in Secion 2. A shor overview of empirical research and descripion of he model and economeric mehodology are presened in Secion 3. Empirical resuls on he bank lending channel in Lavia are discussed in Secion 4, while Secion 5 checks he robusness of hese resuls. The las secion concludes. 3 . THE BANK LENDING CHANNEL. Ineres Rae and Credi Channels: a Brief Overview of Theoreical Conceps According o he radiional ineres rae channel (or money channel, a change in policy-induced ineres raes affecs long-erm ineres raes, which, in urn, influence he real economy by impacing various relaive prices in he economy. The emphasis of ineres rae ransmission mechanism is on he real raher han nominal ineres rae and he long-erm raher han shor-erm ineres rae.(27 The key is sicky prices, so ha expansionary moneary policy ha lowers he shor-erm nominal ineres rae also lowers he shor-erm real ineres rae. The expecaions hypohesis of he erm srucure suggess ha a lower real shor-erm ineres rae leads o a fall in he real long-erm ineres rae. In an overview of compeing views on moneary ransmission, Ch. Bean e al. (4 denoe he following ingrediens of he ineres rae channel. Firs, higher ineres raes and herefore higher cos of capial induce increasing reurns required for an invesmen proec and diminishing invesmen expendiures. Second, an increase in ineres raes alers consumpion: he impac of moneary ighening can be decomposed ino a subsiuion and income effec. The former is negaive, as higher ineres raes decrease he price of fuure consumpion, while he laer depends on ne asse posiions of consumers. Third, in he case of a flexible exchange rae regime, ineres rae movemens make he exchange rae volaile hereby alering price compeiiveness and affecing ne expors. Ineres rae movemens will also have an impac on he supply side of he economy hrough ineremporal subsiuion in labour supply. The ineres rae channel heory assumes ha financial inermediaries do no play any special role in he economy. B. S. Bernanke and A. S. Blinder (5 show ha he radiional ineres rae channel relies on a leas one of he hree assumpions: loans and bonds are perfec subsiues o borrowers, 2 loans and bonds are prefec subsiues o lenders, or 3 he commodiy demand is insensiive o loan rae. The poin of deparure of he credi view is he reecion of he assumpion ha bonds and bank loans are perfec subsiues. B. S. Bernanke and M. Gerler (6 sae ha ..according o he credi channel heory, he direc effecs of moneary policy on ineres rae are amplified by endogenous changes in he exernal finance premium, which is he difference in cos beween funds raised exernally (by issuing equiy or deb and funds generaed inernally (by reaining earnings. The size of he exernal finance premium reflecs imperfecions in he credi markes ha drive a wedge beween he expeced reurn received by lenders and he coss faced by poenial borrowers. According o he credi view, a change in moneary policy ha raises or lowers marke ineres raes ends o change he exernal finance premium in he same direcion . Based on he assumpion of informaional imperfecions in financial markes, he credi channel assigns an acive role o he supply of bank loans. Therefore, he credi channel sipulaes ha moneary policy can affec no only he demand for loans, bu also he supply of loans. B. S. Bernanke and M. Gerler (6 define wo subchannels of he credi channel: 4 balance shee channel (or broad credi channel wih a focus on poenial impac on borrowers' balance shees and income saemens; bank lending channel (or narrow credi channel wih a focus on he supply of loans by credi insiuions. The balance shee channel does no specifically concenrae on bank loans bu refers more generally o he overall supply of funds. This channel may work even if loans and bonds are perfec subsiues in he balance shees of banks and firms. The balance shee channel is based on he assumpion ha he exernal finance premium should depend on borrower's financial posiion. Moneary policy changes can affec he borrowers' risk characerisics, as higher ineres raes are expeced o weaken he borrowers' financial posiion. According o B. S. Bernanke and M. Gerler (6, a igh moneary policy weakens direcly he borrowers' balance shees in wo ways. Firs, higher ineres raes increase ineres paymens, weakening he financial posiion of borrowers. Second, rising ineres raes are ypically associaed wih declining asse prices, which reduce he value of borrowers' collaeral. Moreover, a igh moneary policy may influence he financial posiion indirecly, decreasing he demand for firm's oupu, while various fixed coss do no adus in he shor run. A change in borrowers' risk ranslaes ino a shif in he supply curve of funds due o he exisence of asymmeric informaion among lenders and borrowers. The bank lending channel focuses more narrowly on he special role of banks in he moneary ransmission mechanism, as moneary policy may also affec he exernal finance premium by shifing he bank loan supply. This channel may be a work only under he following condiions. Moneary policy should significanly affec he supply (or relaive pricing of bank loans. The model designed by B. S. Bernanke and A. S. Blinder (5 suggess ha a igh moneary policy affecs he reserve posiions of banks, also influencing he supply of bank loans. The key assumpion is ha, following a reducion in reserves, banks canno urn freely o he bond marke due o exernal finance premium. In oher words, deposis and bonds should be imperfec subsiues for banks. Bank loans and bonds should be imperfec subsiues for borrowers and changes in loan supply should affec real aciviy. B. S. Bernanke and M. Gerler (6 argue ha his condiion is very likely as banks remain he dominan source of inermediaed credi specialising in overcoming informaional problems and oher fricions in credi markes. The balance shee and bank lending channels should no be considered as an alernaive o he radiional moneary ransmission mechanism. B. S. Bernanke and M. Gerler (6 sress ha ..we don' hink of he credi channel as a disinc, freesanding alernaive o he radiional moneary ransmission mechanism, bu raher as a se of facors ha amplify and propagae convenional ineres rae effecs. For his reason, he erm credi channel is somehing of a misnomer; he credi channel is an enhancemen mechanism, no a ruly independen or parallel channel . 5 In addiion, unlike he sandard ineres rae channel, he impac of moneary policy on he real economy, working hrough he balance shee and bank lending channels, has imporan disribuional consequences. Banks of differen deposi dependence and firms wih differen financial posiions and dependence on bank loans are unlikely o be equally affeced by moneary policy shocks..2 Deerminans of he Bank Lending Channel According o heoreical conceps, he wo necessary condiions for he exisence of he bank lending channel are he abiliy of moneary policy o affec he bank loan supply, and imperfec subsiuion beween bank loans and bonds for borrowers. Consequenly, he significance of he bank lending channel is deermined by wo facors: he srengh of moneary policy impac on he bank loan supply, and dependency of borrowers on bank loans. The effec of moneary policy on he supply of bank loans depends on he characerisics of he banking secor. Overall, he sronger he naion's banking secor, he weaker he expeced impac of policy movemens is; balance shees of large, healhy banks are no sensiive o policy because heir reserve conracion can be readily offse wih alernaive forms of financing wihou involving reserve requiremens.(9 There are various indicaors of financial srengh of he banking secor in he lieraure. The size of banks, marke concenraion, capialisaion and liquidiy are among he commonly menioned facors.(9; 0 A relaively small size of banks, weak bank marke concenraion, low liquidiy and capialisaion would sugges a sronger lending channel, as such banks are more exposed o marke imperfecions and will face more difficulies in aracing non-deposi financing. Financial srengh is also characerised by loan loss provisions, operaing coss and reurn on asses as well as he number of bank failures in he pas. Anoher imporan facor is ownership srucure of he naional banking secor. Sae influence exered eiher hrough direc public ownership of banks, sae conrol or public guaranees provides addiional funding possibiliies and reduces informaional asymmeries. Foreign involvemen in he domesic banking secor also weakens he bank lending channel, as foreign bank subsidiaries may face fewer financing consrains due o poenial supply of addiional funding from heir paren banks.(5; 0 A. K. Kashyap and J. C. Sein (20 argue ha he effec on he bank loan supply depends on he regulaory framework, as risk-based capial requiremens can ie a bank's abiliy o exend loans o is level of equiy capial and consrain lending. On he oher hand, bank lending behaviour could be also affeced by deposi insurance requiremens, as high deposi insurance decreases he risk level for cliens. A lower risk level reduces deposi coss for banks, hus increasing bank dependency on his ype of liabiliies. Finally, he speed of moneary ransmission depends on he bank loan mauriy and ineres rae ype. The bigger he share of shor-erm loans wih a floaing ineres rae, he faser he response of loan supply o changes in moneary policy will be. 6 Regarding dependency of borrowers on bank loans, i is usually explained by he fac ha banks play a special role in he financial sysem because hey are paricularly well suied o solve asymmeric informaion problems in credi markes.(27 The bank-dependen borrowers small and medium sized firms and households suffer mos from he asymmeric informaion problems. The higher he share of such borrowers in he credi marke, he higher he bank-dependency raio is. Moreover, he bank dependency is also driven by availabiliy of non-bank finance. Relaively low capial marke capialisaion compared wih he bank asses and loans implies higher bank dependency and sronger bank lending channel of moneary ransmission. 2. A SHORT DESCRIPTION OF LATVIA'S BANKING SECTOR 2. Imporance of he Banking Secor for Lavia's Financial Sysem The banking secor plays a significan role in Lavia's economy and dominaes oher ypes of financial inermediaion (see Table 2.. The developmen of he banking secor was exremely dynamic during he las years, wih he bank oal asse raio o GDP increasing from 77% in 2002 o more han 40% in The growh of bank loans o residens was even more rapid, and heir raio o GDP increased almos hreefold beween 2002 and 2006 mosly due o he growh in loans o households. In 2006, he share of households in oal loans o residens was almos one half. Table 2. Financial inermediaion in Lavia (% o GDP Toal bank asses Bank loans o residens of which: o non-financial corporaions o households Leasing companies' asses Invesmen fund asses Privae pension fund asses Insurance corporaions' asses Ousanding deb securiies of corporae secor of which non-banks Sock marke capialisaion of which non-banks Sources: Bank of Lavia, FCMC, CSB, Riga Sock Exchange and LCD. Oher ypes of financial inermediaion are less imporan and heir developmen is no so impressive, excep for leasing companies' asses o GDP ha doubled during he given four year period. Alhough he increase in asses of invesmen funds was impressive as well, heir relaive size is sill negligible. The asses of privae pension funds and insurance corporaions were almos unchanged relaive o GDP during he observed period. Sock marke capialisaion o GDP was 2.7%, quie low compared wih bank oal asses and loans. The deb securiies marke is sill undeveloped in Lavia; moreover, i is dominaed by bank deb securiies. 7 Table 2.2 Inernaional comparison The relaive size of Lavia's banking secor is comparable wih ha of developed counries (see Table 2.2 for inernaional comparison. Toal asses of Lavia's banks o GDP are lower han in he euro area and is wo larges counries Germany and France. However, he relaive level of bank loans o non-financial corporaions is quie comparable wih euro area figures. I is ineresing o noe ha bank oal asses and loans o non-financial corporaions relaive o GDP are wo imes higher in Lavia han in he USA. In conras o he banking secor, he sock and deb securiies markes are significanly weaker han in he developed counries. Lavia's sock marke capialisaion o GDP is 0 imes smaller han in he USA and 5 7 imes smaller han in he euro area. This gap is even larger for he deb securiies marke. (end of 200; % o GDP USA Euro area Germany France Lavia Toal bank asses Bank loans o non-financial corporaions Ousanding deb securiies of non-financial corporaions Sock marke capialisaion Sources: (0, Bank of Lavia, Riga Sock Exchange and LCD. The facs above prove he dominan role of Lavia's banking secor in financial inermediaion sysem, which resuls in a high degree of bank dependency of local borrowers. This dependency is especially pronounced because of a high share of loans o households in he oal bank loan porfolio. 2.2 Srucure of Lavia's Banking Secor A he end of 2006, here were 2 banks in Lavia (of which nine were subsidiaries of foreign banks and hree branches of foreign banks (see Table 2.3. The number of banks was almos unchanged during he las five years, while here was an increase in he number of foreign branches and subsidiaries. Alhough he number of banks is relaively large aking ino accoun he size of Lavia's populaion (here is one bank per 95 housand inhabians, he banking secor is dominaed by few large banks, while oher banks are r
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