The Fed Relies on Healthy Banks to Transmit Monetary Policy

Federal Reserve Chair Janet Yellen testifies on Capitol Hill before the Joint Economic Committee, on November 17, 2016.

It may seem hard to believe, but until relatively recently, economists did not think banks had much to do with the money supply, even though that is where one goes to get money. In traditional monetary policy—see part one of this series—banks do not play much of a role, but economists have known for a few decades that banks are a big deal for monetary policy in the United States. Approaches that focus on banks’ incentives—generally referred to as taking the “credit view”—have rapidly gained prominence because they capture a significant blind spot of simplified analysis.

When recessions are followed by periods of slow bank lending growth, the new, small, rapidly growing firms that provide much of the economic growth in an expansion cannot get the capital they need to grow. This is a pretty big deal for monetary policy because a clearer understanding of how banks behave is key to grasping how banks respond during and after recessions, when restoring economic growth is most crucial. Typically, economists use the term “channels” to describe how monetary policy flows down to affect the economy—see part one for examples. Proponents of the credit view note that banks sit in the middle of these channels. Because of this, banks’ incentives play a large enough role that it is useful to think of banks as providing additional channels of monetary policy.

Bank-based lending channel

When large companies and governments need to raise funds, they can issue stocks and bonds directly. But for everyone else, borrowing comes in the form of bank loans. Bank loans are imperfect. For example, early investors in startups accept lots of risk but can make huge returns on their investments, while when a bank loans to a startup, it only gets its loan paid back with interest—which is why banks do not typically loan money to startups. Winning big as a bank means getting everyone to pay back their loan without defaulting, not finding the next Facebook, so banks are naturally risk averse at least with respect to their lending behavior.

Under normal circumstances, banks cannot immediately get the money back from existing loans, so they must adjust to changes in monetary policy through their new loans. When higher rates affect banks’ ability to make new loans, the effects of this relatively minor tightening of monetary policy can result in banks restricting new credit significantly. This risk-averse behavior from banks makes sense from their perspective but does not fit with older macroeconomic models, which did not take into account the way existing loans can force banks to make large changes in their new loan behavior.

Policymakers’ current focus on bank-based lending is partly an effort to catch up with economists’ understanding that prudent bank behavior can amplify the effects of monetary policy. Both formal modeling efforts and policy discussions have pointed to behavior that is rational from the perspective of individual banks leading to more dramatic reductions in credit availability, and thus less money available to spend and less economic growth than simple theories predict. 

Bank capital channel

Banks typically fund loans with a variety of sources, but in recent years and especially for the largest institutions, the overwhelming majority of working capital comes from funds that the bank borrows. Banks cannot borrow indefinitely; to limit risk regulators determine how much equity a bank has and limit how much it can borrow based on how much of a cushion the equity could provide based on an international framework.

Here’s where things get interesting—or complicated, depending on your perspective. The simple story of monetary policy says that raising interest rates slows investment demand, both reducing demand for loans and making it more likely that borrowers default because, aside from mortgages, virtually all bank loans have variable interest rates. Banks have equity to protect against these defaults, but that equity is in the form of payments from existing loans and assets the bank holds. When rates go up, asset prices fall and defaults become more common, so banks have less equity, but the bank still owes its creditors as much as it borrowed.

To strengthen their balance sheets in response to a decline in asset values prices, banks tend to curtail new lending activity in order to bring the ratio of loans to capital back into balance. Conversely, expansionary monetary policy, which results in lower rates, affects bank capital in two ways: First, the value of bank capital increases when rates are cut, allowing banks to make more loans. Second, a cut in interest rates makes it cheaper for banks to borrow additional funds. However, it takes a while for these lower interest costs to be passed on to existing borrowers, thus banks become more profitable and have more equity to work with in the short term, providing additional ability to generate new loans. 

Conclusion

Economists’ understanding of the importance of banking in monetary policy is relatively recent and relatively crude, especially with innovation in the banking sector changing the underlying structure of financial markets all the time. But even this somewhat simple explanation of how banking and monetary policy are linked has become hugely important for the nation’s economic health.

Michael Madowitz is an Economist at the Center for American Progress.