New Research analyses Bank Lending, Collateral, and Credit Traps in a Monetary Union

• Banking-sovereign nexus may impair the transmission of monetary policy to corporate lending
• Banks in stressed countries may search for high sovereign yields rather than lending to firms
• Sovereign risk can generate negative cross-border effects on lending

The Central Bank’s new Research Technical Paper on ‘Bank Lending, Collateral, and Credit Traps in a Monetary (PDF 1.3MB)Union’, provides a theory to investigate the transmission of non-standard monetary policy to corporate lending in a monetary union where financial frictions limit access by firms to external finance.

Published today, the model predicts that the exposure of the banking sector to sovereign risk can impair the transmission of monetary policy to corporate lending in stressed countries and can generate the risk of contagion across economies.

In the model, the liquidity injected into the banks in high risk countries results in financing the sovereign rather than boosting lending in some circumstances. This theoretical mechanism sheds light on the heterogeneous transmission of the ECB’s policy measures to the economy of stressed countries during the euro sovereign debt crisis.

The paper also highlights that sovereign risk in one country can generate negative spill-over effects on lending throughout the monetary union via variations in the price of assets used as loan collateral.

This theory has policy implications. First, it can be instrumental to promote cross-border lending in the Euro Area, as well as weakening the link between a country’s banking sector and the health of its public finances.

Second, a timely intervention in response to sovereign markets turmoil would lessen banks’ search for sovereign yields and allow a more effective monetary stimulus to private lending in stressed countries. Third, non-standard measures able to improve liquidity of collateral markets circumventing the banking intermediation channel may enhance the monetary stimulus.

Read our Research Technical Papers.