The monetary policy transmission mechanism: in light of recent changes in banking and financial innovation
Speech by Jürgen Stark, Member of the Executive Board of the ECBSpeech delivered at the conference “The implications of changes in banking and financing on the monetary policy transmission mechanism”Frankfurt am Main, 29 November 2007
Over the past 10-15 years we have experienced massive changes to the way banks conduct their business as well as to the financial system more generally. The multitude of financial innovations is likely to have impacted on the monetary policy transmission mechanism and in the process the conduct of monetary policy might have become more complex than in the past.
Questions concerning the implications of new financial instruments and the changing nature of banking have indeed come to the fore in the course of the past months’ financial market tensions, which have posed new challenges to central bankers around the world.
1. The role of banks in the monetary policy transmission mechanism
Especially in the euro area financial system banks are of major importance for the financing of firms and households. This implies that the extent to which banks adjust their lending and the pricing of loans in response to monetary policy actions can be an influential channel through which monetary policy affects the economy. In the economic literature, the role of banks in the monetary policy transmission process is seen as working through various channels.
One transmission channel affected by bank behaviour is the degree and speed with which banks pass on changes in policy rates. It has been shown that banks tend to adjust only sluggishly their lending rates in response to changes in monetary policy rates.  The stickiness of bank rates has been found to rely among other things on financial structures and competition within the banking sector as well as on competition from market-based sources. 
Another transmission channel often cited in the literature and having received increasing attention over the past two decades is the “credit channel”. According to this view, owing to informational asymmetries and principal-agent problems between banks and their borrowers, monetary policy may impact on the supply of loans.
This could, for example, be the case if following a monetary policy tightening certain banks face balance sheet constraints, such as lower liquidity or capital holdings, and hence may choose to restrain lending, as prescribed by the “bank lending channel” (or “narrow credit channel”).
Monetary policy via the cash flows of potential borrowers and the value of their collateral may likewise influence the creditworthiness of bank borrowers leading to a change in their external financing premium as perceived by the banks. This, in turn, may induce banks to alter their supply of loans to these borrowers (the “broad credit channel”).
All in all, the fact that monetary policy can affect the balance sheets of banks and their borrowers may amplify the impact of monetary policy on the wider economy.  Furthermore, bank credit has also been shown to be related to the boom and bust of economic cycles, for example as evidenced by the correlation between credit cycles and assets cycles. 
2. Effects on the monetary policy transmission mechanism of recent changes in financial structures and financial innovation
This brief literature review of the role of banks in the monetary policy transmission mechanism simply serves to underline the importance of understanding the implications on the monetary policy transmission mechanism of recent changes in the financial landscape.
Both from an academic and policymaking viewpoint, it is highly pertinent to enhance our knowledge regarding how the emergence of new investors in the credit markets, the innovation of structured credit products and the concurrent transformation of the traditional bank business model, has influenced and interacts with monetary policy.
Importance of non-bank financial intermediaries as providers of financing
The past decades have seen a gradual decline in the importance of the traditional model of financial intermediation whereby banks obtain funding mainly via insured deposits and use these funds to grant loans that they hold to maturity. This model has over time been replaced, or at least complemented, with a business model where banks increasingly rely on market-based funding and transfer a major part of their credit risk off-balance sheet.
This process has been termed “disintermediation”. However, arguably banks are still among the central players in the process of channelling funds from those in the economy with net savings to those with a net financing need.
Nevertheless, the role banks play in this process has been altered considerably in the course of the past decades. In addition, over the past 20-30 years we have observed a growing importance of a range of non-bank financial intermediaries, which play an increasing role in the intermediation process and in a sense have “reintermediated” some of those assets leaving the banks’ balance sheets. 
In a sense one could say that the chain of intermediating funds between savers and investors has become longer than in the past. While this process to a large extent originated in the US, we have observed a similar development in the euro area financial system, whereby non-bank financial intermediaries such as investment funds, insurance companies and pension funds and credit card operators have gained increasing pertinence.  More recently, also other financial players such as hedge funds, CDO funds, special purpose vehicles (SPVs) and conduits have expanded significantly.
The emergence of these new players has created a larger investor base and hence has, on the one hand, facilitated the placement of financial assets originated by banks (such as securitised loans) and, on the other hand, encouraged market-based financing (such as commercial papers and corporate bonds). All in all, these developments have transformed the financial system making it more market-oriented and have also somewhat blurred the distinction between the traditional categories of bank-based and market-based systems. 
Whereas these developments have made financial intermediation more market-based, it has also allowed a wider dispersion of risks across the system and broadened the participation in the reallocation of financial assets.
From a monetary policy perspective, it may be important to note that the fact that non-bank lenders have become increasingly important, in turn may have reduced the number of borrowers that are entirely bank-dependent. Against this background, the growing importance of non-bank lenders should at first sight render the bank lending channel of monetary policy less effective, as borrowers to a larger extent would be able to obtain financing outside the banking system. While non-bank lenders do not have access to insured deposit funding, they typically have relatively easy access to market-based funding and thus in normal circumstances should not be particularly constrained by changes in monetary policy.
During more distressed periods, however, it cannot be ruled out that monetary policy will exert a significant influence on the balance sheet of the often more risk-tolerant non-bank lenders. As Ben Bernanke recently noted, also non-bank lenders face an external finance premium, which may be affected in a similar manner as that of banks by changes in monetary policy.  Moreover, Rajan (2005) has suggested that many non-bank financial intermediaries are likely to operate with more risk-sensitive, and hence more procyclical, business models. 
It is not clear a priori to what extent the changes in financial intermediation has heightened or reduced the importance of the credit channel of monetary policy transmission. This is an area where further research is needed.
Securitisation and credit derivatives
The recent years’ favourable environment of low risk, low inflation, expansion of financial market liquidity and technological progress combined with a long-running process of financial deregulation has spurred a large amount of financial innovations. One of the most remarkable developments in this regard has been the explosion of securitisation activity and the spreading of new innovative credit risk transfer instruments more generally.
To put this into perspective,
Recent estimates suggest that the volume of global asset-backed securities by the end of 2006 amounted to almost $11 trillion, of which little more than half related to (mainly US) residential mortgage-backed securities. 
Whereas securitisation activities in the US financial system have been important for a number of years, in a euro area context they have only developed more recently. Yet, the growth of securitisation markets in the euro area has been remarkable.
Thus, the issuance of euro-denominated asset-backed securities increased from around €50 bill. in 1999 to almost €300 bill. in mid-2007. 
Similarly, the issuance of euro-denominated collateralised debt obligations (CDOs) increased from basically nil in 1999 to around €180 bill. in 2006. 
At a global level, it has been estimated that alone between 2004 and 2006 the issuance of CDOs almost tripled amounting to $489 bill. in 2006. 
A major part of the CDOs are so-called synthetic securitisation instruments, which are structured using credit derivatives, such as credit default swaps (CDS) and credit-linked notes.
Thus, another illustration of the surge in the use of structured credit products is that the notional amounts outstanding in the global CDS market rose from basically nothing in 1999 to estimates ranging from $20-26 trillion. 
Apart from the fact that securitisation and credit derivatives have contributed to spreading risks more widely, it has also fundamentally changed the nature of banking and in the process may have altered the credit channel of monetary policy in important ways. This may be illustrated by the following considerations:
First, in the case of “true sale” securitisation, in which the underlying assets are removed from the originating bank’s balance sheet, it has provided banks with an additional funding source. This is likely to have contributed to an increase in bank loan supply, all things being equal.
Second, securitisation by transferring credit risk off-balance sheet may help originating banks obtaining capital relief, which in turn may free up funds for additional provision of loans. This was, in particular, an issue under the Basel I capital adequacy framework where securitisation was often perceived as a mean for banks to arbitrage on the level of required regulatory capital. The new Basel II-framework aims, among other things, at correcting for such regulatory arbitrage activities. 
Third, the use of structured credit products should be seen in the context of advances in bank risk management systems. Notably, the combination of new credit risk modelling techniques and credit derivatives has allowed an improved allocation and dispersion of banking book risk at the portfolio level, which in turn may have enhanced banks’ ability to expand their balance sheets.
All in all, the emergence of securitisation and credit derivatives are likely to have led to a change in bank lending dynamics, possibly leading to an increase in bank loan supply.  Hence, the advances in credit risk transfer instruments by expanding the breadth of the credit markets is likely to have reduced the effectiveness of the bank lending channel in normal circumstances.
Furthermore, with respect to the “broad credit channel”, the enhanced liquidity and continuous pricing offered by credit risk transfer instruments may have accentuated the sensitivity to changes in monetary policy on the external finance premium that borrowers face when trying to raise financing. 
At the same time, the advent of structured credit products has provided the markets with a range of new tools to assess the creditworthiness of borrowers. This increase in credit market information may contribute to compressing the overall external finance premium and hence reducing the effectiveness of the broad credit channel.
These considerations, however, may only apply during tranquil periods. Indeed, recent events have shown that during periods of stress the securitisation and credit derivatives markets could grind to a halt. This could have a negative impact on bank loan provision, which in turn could put banks’ liquidity and capital positions under stress and potentially may adversely affect bank credit standards.
What have we learned from recent credit market events?
It is premature to draw any firm conclusions from the recent developments. As an interim assessment, the following remarks can be made: The recent tensions in global credit markets were to a large extent fuelled by an emergent gap between the information available to credit originators and end-investors in the credit market. Emanating from the rise in arrears in the US sub-prime mortgage market, marked-to-market losses on asset-backed mortgage securities led to a more broad-based uncertainty about the value of structured credit products in general.
The heightened uncertainty about the composition and value of structured credit products resulted in a loss of liquidity in these markets, which in turn left banks holding assets that they had planned to off-load and facing obligations to off-balance sheet entities. This “reintermediation” of assets in some cases have exerted considerable pressure on banks’ liquidity and capital ratios. In the absence of transparency about banks exposures to these products, banks hoarded liquidity, which consequently led to a tightening of money market conditions.
The recent events clearly highlighted some structural deficiencies related to structured credit products. Among these weaknesses was – firstly – the growing complexity of some of the instruments, which turned out to be more difficult to value when markets came under stress. Secondly, the strong reliance on ratings in valuing structured credit instruments in retrospect appears critical, as – thirdly – does the apparently inadequate disclosure of financial institutions’ exposure to structured credit products and related off-balance sheet entities.
The recent turmoil indeed served to illustrate that due to the opaqueness of the instruments and a widespread reliance on market perceptions and ratings, episodes of mispricing of credit risk may be followed by abrupt adjustments in credit conditions.
Moreover, the events have raised questions about the effects of credit risk transfer instruments on banks’ monitoring role.
To what extent has the ability to transfer part of the credit risk changed banks’ and other financial intermediaries’ incentives to monitor the loans that they have originated? 
Could it be that the move from a “buy and hold” to an “originate and distribute” banking model, by reducing the incentives of banks to monitor their borrowers, may lead to an increase in asymmetric information?
The emergence of new credit risk transfer instruments may have enabled the spreading of risks more widely across the financial system and possibly created greater access to financing for firms and households. At the same time, as also illustrated by the recent events, it may also have accentuated economies’ exposure to financial-sector driven tensions.
3. Overall assessment and directions for future research
What the recent credit market tension confirmed was the notion that monetary policymakers should not restrain themselves to only monitor credit expansion within the banking sector. Policymakers should also focus attention to the wider credit markets, such as developments in the non-bank financial intermediary sector and structured credit products. At the ECB we are keenly aware of this and we constantly strive to improve our analysis of money and credit from a broad perspective of the financial system.
The structural changes to banking and financing observed over the past decades indeed have provided monetary policy with new challenges. Much progress has already been made on the academic front in enhancing our understanding of the monetary policy implications of these changes. However, the recent weeks’ events in global credit markets illustrate that we have to enhance our knowledge and understanding even further. This is an area where more research will be conducted in the future.
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 For the US see e.g. Hannan and Berger (1991), Berger and Udell (1992), Mester and Saunders (1995), Berlin and Mester (1999). For more recent studies on the euro area see e.g. Mojon (2001), de Bondt (2002, 2005), Gambacorta (2004), Sander and Kleimeier (2004) and Kok Sørensen and Werner (2006). See also Berger et al. (2007) for a comparison between the US and euro area pass-through.
 See e.g. Cottarelli and Kourelis (1995), Mojon (2001) and Gropp et al. (2006).
 See Bernanke and Blinder (1988), Bernanke and Gertler (1989, 1995), Bernanke and Gertler and Gilchrist (1999) and Kashyap and Stein (2000) for some of the seminal contributions to this line of the literature. Empirical findings for the euro area can be found in Ehrmann et al. (2001), Angeloni and Ehrmann (2003), Gambacorta and Mistrulli (2004), Altunbas et al. (2004), Kishan and Opiela (2006), Van den Heuvel (2002).
 See e.g. Borio and Lowe, 2002 and 2004.
 See also Rajan (2005).
 See e.g. the article entitled “Recent developments in financial structures in the euro area” in the ECB Monthly Bulletin October 2003.
 See also Trichet (2007).
 See Bernanke (2007).
 This, according to Rajan, is due to the fact that the incentives of the typically more “arm’s length” non-bank financial intermediaries, such as hedge funds, contribute to increased risk taking and thus “heighten the possibility of booms and busts”; see Rajan (2005).
 See Bank of England (2007), Financial Stability Report October 2007.
 Based on a 12-month moving average; source: European Commission.
 According to Creditflux.
 According to the Securities Industry and Financial Markets Association.
 See e.g. BIS, British Bankers’ Association and ISDA.
 It is currently uncertain what the net effect on securitisation activities from the introduction of Basel II-based capital requirements will be. Thus, according to the latest Quantitative Impact Study (QIS5) capital requirements related to banks’ securitised assets may either increase or decrease depending on the type of bank and on the approach applied (“standardised” or “IRB”); see BCBS (2006).
 See e.g. Estrella (2002), Loutskina and Strahan (2006), Hirtle (2007) and Altunbas et al. (2007).
 See also Zhu (2006) which shows that credit derivatives premia (i.e. CDS swap spreads) respond more to changes in the availability and cost of financing compared with corporate bond spreads.
 See also Holmström and Tirole (1997).
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