... monetary policy matters most for those with the least liquid balance sheets.
How does monetary policy actually work? In What Do A Million Banks Have To Say About The Transmission Of Monetary Policy? (NBER Working Paper No. 6056), NBER Research Associates Anil Kashyap and Jeremy Stein tap into a massive database to examine how shifts in monetary policy have affected the lending behavior of individual banks over a period of nearly 20 years. Their main finding is that changes in monetary policy have had a more powerful impact on those banks with lower ratios of cash and securities to assets. Moreover, this result is driven almost entirely by the smaller banks in their sample.
The authors disagree with the assumption implicit in most textbook models that "banks don't matter" when it comes to monetary policy. Instead, they take a bank "lending view" of monetary transmission; in other words, the Fed can shift bank loan supply schedules through its open market operations. The bank lending view starts with the observation that banks (especially small ones) cannot easily tap uninsured sources of external funds to make up for a Fed-induced shortfall in insured deposits. For example, if the Fed contracts reserves and a bank faces an outflow of insured deposits, it could conserve on reserves by issuing large, uninsured certificates of deposit. But that would expose investors to credit risk. Instead, the bank may choose to cut its loans. So, changes in monetary policy can, in principle, affect lending behavior.
A body of research has built up over the years showing how changes in Fed policy are associated with movements in aggregate bank lending volume. Nevertheless, it has remained difficult for economists to disentangle loan supply from loan demand effects. The authors bring new data to bear on the problem by creating a panel that includes quarterly data on almost every insured commercial bank in the United States between 1976 and 1993. The approximately one million "bank quarters" were drawn from the Consolidated Report of Condition and Income (better known as the Call Reports) that all banks must submit to the Fed. The authors also use three measures for capturing the stance of monetary policy: an index based on a reading of Federal Open Market Committee documents; the federal funds rate; and a measure based on a structural statistical model.
Their key result is that the effect of monetary policy on individual bank lending is much stronger for some banks than for others. Specifically, within the class of small banks, monetary policy matters most for those with the least liquid balance sheets. It remains an open question just how important the lending channel is for investment and gross domestic product. Still, the "bottom line is that it now seems pretty hard to deny the existence of a lending channel of monetary policy transmission," Kashyap and Stein conclude.