As I noted in a previous post, monetary policy works through various channels, one of which is the "bank lending channel." Lower policy rates, as witnessed in the past few months and shown below, should induce greater lending.

Figure 1: Nominal effective Fed Funds rate (blue), and real (red). NBER-defined recession dates shaded gray. Real Fed Funds rate calculated by subtracting lagged CPI-All 12 month change. Sources: Federal Reserve Board via St. Louis Fed FREDII, and author's calculations. Note: sample period used in Cetorelli and Goldberg is 1980Q1-2005Q4.

According to a new paper by Nicola Cetorelli and Linda Goldberg, presented at a recent Bundesbank conference, the magnitude of the impact depends on the degree to which the banking system is internationalized. While the usual tendency to associate financial globalization with the increasing internationalization of bond and equity markets, recent events have brought home the reality of the increasing internationalization of banks. From the introduction to Cetorelli and Goldberg:

Monetary policy transmission through banks has long been noted as one of the key channels for policy effectiveness. Seminal work by Kashyap and Stein (1994, 1995, 2000) shows that this lending channel differs across players within the financial system of the United States. While lending of small banks appear to be highly responsive to monetary policy shocks, the same is not true for larger banks. The main reason for the difference within the population -- the authors argue -- stems from the presumed greater ability of large banks to substitute reservable deposits with other external sources of funds, so that the shock to the liability side of their balance sheet from monetary policy is not transmitted to the asset side.

...

...We conjecture and show that this process of "globalization" of U.S. banking has had a deep and pervasive impact on the transmission mechanism of monetary policy. Barring truly global events, banks with activities in multiple countries can reallocate funds in the event of a liquidity shock occurring either domestically or abroad. Our argument thus presumes that banking organizations actively operate internal capital markets, in which the global banks move liquid funds between domestic and foreign operations on the basis of relative needs. Hence, according to this conjecture the shock to reservable deposits caused by a change in monetary policy would be absorbed through internal sources of funding rather than exclusively through an attempt to access external capital markets.

...

Our results also show that the total lending channel consequences of U.S. monetary policy are underestimated by a focus purely on U.S. markets. We look at the response of lending of the foreign offices of U.S. global banks to a change in domestic monetary policy and find evidence consistent with this the existence of an international mechanism of transmission of monetary policy. Hence, monetary policy through the lending channel may not be losing its effectiveness overall but rather it may be increasingly felt outside of the traditional field of observation. In this sense, our work directly compliments the Peek and Rosengren (1997, 2000) findings that banks are specifically involved in the international transmission of shocks. In our case, results based on bank-specific data demonstrate a direct mechanism underlying the type of monetary policy transmission across countries documented in analyses of macroeconomic data, as in Kim (2001), Neumeyer and Perri (2005), Canova (2005) and Goldberg (2005).

The differential between the impact of monetary policy shocks to bank lending in domestic versus international banks is highlighted in Table 3 from the paper.

Table 3 from Nicola Cetorelli and Linda Goldberg, "Banking Globalization, Monetary Transmission, and the Lending Channel," mimeo, May 19, 2008.

In terms of the current situation, my interpretation of these results is that the loosening of monetary policy, at least as measured by the real Fed Funds rate, will have a smaller effect on domestic macro activity than otherwise, as global banks shift around funds between the parent firm and affiliates.

Note that while the expansionary impact of monetary policy on domestic activity is attenuated by this effect for international banks, the contractionary effect of monetary policy is also reduced, should the Fed raise interest rates to reduce inflationary pressures.

The results of this paper are consistent with the view that while loosening of US monetary policy might induce greater lending overseas by branches of US banks, thereby tending to support rest-of-world economic activity, they also imply that negative shocks to the assets of US banks will also tend to reduce lending abroad. Hence, deleveraging by domestic banks has global (or at least rest-of-OECD) implications. That means both negative and positive shocks will be propagated abroad. In this sense, I think decoupling of the major developed economies is even less likely to occur.

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Menzie Chinn

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