The credit channel is an enhancement mechanism for traditional monetary policy transmission, not a truly independent or parallel channel.Discuss.

From a theoretical point of view, the credit channel composed of the bank lending channel and the balance sheet channel could be completely incorporated in the traditional monetary policy transmission if we operated in a world with no asymmetric information, moral hazard, differential taxation, agency, search and transactions costs, and if borrowers had homogenous preferences over internal and external sources of funding. However, as soon as we relax these implausible assumptions, the credit channel can become a truly independent or parallel channel. Some borrowers, such as small firms or consumers, are likely to be unable to raise funds on the equity market or through bond issuing. This might occur because they are unable to signal their repayment characteristics, or because individual lenders may be willing to lend long term funds only at a prohibitively high default risk premium. Banks, having a comparative advantage in terms of monitoring, transaction costs, and the ability to match lenders and borrowers, will play a crucial role in this setting. Loans become an imperfect substitute for other forms of finance, and any monetary shock that significantly decreases the supply of loans, will affect the cost of finance for the loans- dependent borrowers by more than the traditional monetary (increase in interest rate) mechanism would imply. Consider a monetary policy tightening, implemented through open-market sales, that raises the real interest rate. Bank reserves decrease, i.e. there is a shock to banks balance sheets. The bank lending channel implies that there will be a change in the cost and availability of bank loans. Banks may increase the bank lending rate by more than the increase in the interest rate, or they can impose tighter collateral requirements in order to ration lending. In both cases the change in the real interest rate is no longer a valid indicator of the change in financing costs for the loans- dependent agents. A credit crunch results as these agents start competing for the fewer available funds. Investment decreases by more than the traditional transmission mechanism would suggest and there is a larger decrease in aggregate output. Nevertheless, in this setting, one can still argue that the credit channel is simply an enhancement mechanism for the traditional transmission. Freixas and Rochet (1997) have even argued that this channel is insignificant because banks could simply maintain their loans supplies using instruments that have not been affected by the monetary policy tightening, such as certificates of deposits, commercial papers and long-term debt. Kashyap and Stein (1993) pointed out that if the share of loans provided by banks is small relative to loans provided by other financial intermediaries, there will be margin lenders that will supply funds as bank lending decreases. However the recent crisis has demonstrated that the credit channel is not a mere enhancement mechanism, but a truly independent and parallel channel. Financial innovation and securitization have led to a significant change in banks funding types, which has a significant bearing on their ability to withstand balance sheet shocks. An increase in the real interest rate can lead to a decrease in bank equity prices,

lowering bank capital and implying a capital crunch. Banks with more profitable, but more volatile and non-interest income activities will suffer larger losses and respond by contracting their lending by more. (Gambacorta, Marques-Ibanez, 2011) Furthermore, the bank lending channel enables us to analyse the interactions between financial stability and monetary considerations which are also part of the monetary policy but cannot be accounted for by the traditional transmission mechanism. Stronger prudential regulation, such as increased minimum equity and core capital requirements under Basel III, affect bank loans supply not only in the present, but also in the future by modifying banks risk taking incentives and funding structures. There can also be a shift in banks willingness (not capacity) to supply loans, if banks for e.g. perceive more risk and decide that they need to hold more liquidity. The balance sheet channel is another component of the credit channel which makes it truly independent. It can be analysed using the Bernanke, Gertler, Gilchrist (1999) model in which lenders charge a premium equal to the expected value of monitoring costs. The latter will depend on the financial position of the borrower, which will itself be modified by monetary policy. A monetary tightening resulting in a higher interest rate decreases output, lowers firms asset prices, their Tobins q and their cash flows. The proportion of external to internal funds in the financing of their projects increases. This acts as an adverse signal to lenders because firms have now lower stakes and are therefore more likely to default. The risk premium rises, further dampening investment and output.