There are a number of macroeconomic theories and models which focus on the role of interest rate and exchange rate channels on the impact of monetary policy actions on the real economy. However, credit markets are another channel which plays a very important role in this regard. The credit channel theory of monetary policy emphasizes the critical role of financial assets and liabilities. Rather than categorizing all nonmonetary financial assets as bonds, this theory proposes a demarcation between different nonmoney assets, as well as the varying characteristics of borrowers making some more vulnerable to credit market fluctuations than others. The credit view also discusses agency costs derived for example from imperfect information, which may lead to differences in costs of internal and external finance and hence, may affect investment (Bernanke & Gertler, 1995).
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To understand the credit channel, one must understand that there exists a bank lending channel and the financial-accelerator mechanism, the latter having a broader scope. The bank lending channel stresses on the important function that banks serve in the economy’s financial framework, their contribution in transmitting the monetary policy into the real economy and the special role of bank credit. Monetary policy actions which have an impact on the banks’ reserves will consequently cause interest rate changes as well as adjustments in the asset and liability side of the balance sheet of the banking sector. Adjustments to the liability side will reflect the effects on bank deposits and the supply of money while adjustments to the asset side will be caused by effects on banks’ reserves and interest rates (Walsh, 2003).
Aside from the bank lending channel, credit market imperfections encompass all credit markets as they affect financial transactions and contracts and at times, create a distinct difference between the costs of internal and external finance. This difference is causes by the agency costs which arise due to imperfect information, which will be covered below in detail, as well as the general failure of lenders to keep a close check on borrowers at low cost. Hence, financing costs and availability is largely affected by cash flow and net worth. If a recession occurs in the economy, the firm’s internal finance situation may be harmed and this would lead to a financial accelerator effect, due to which the firm would have no choice but to turn to external funds which would cost a lot more, especially now that with the decline in availability of internal finance. Hence, the monetary contraction policy which was implemented will be further amplified by the credit channel because the firm’s cash flow and profits would decline, and the external finance premium would rise (Walsh, 2003).
Another way in which the credit channel works to transmit the monetary policy to the real economy is when changes in the policy lead to increase or decrease in the efficiency of financial markets or alter how much rationing (which in the context of credit markets is defined as occurring when among a group of firms or individuals who appear to have the same characteristics, only some get loans while the remaining do not) borrowers face. However, credit rationing is not a mandatory condition for a credit channel. A monetary policy contraction will lead to a hike in interest rates, a slower economy, and will consequently lead to decline in firms’ balance sheets. This will in turn lead to higher agency costs and decrease the efficiency of credit allocation (Walsh, 2003).
A credit channel can not exist without there being the requisite imperfections in credit markets, and imperfect information in a credit transaction is the primary reason for the function credit effects play in transmitting monetary policy. This is because the different information that each party in a credit relationship has a direct impact on the credit allocation, efficient matching of borrowers and lenders as well as the characteristics of the credit contract itself. The nature of the credit contract is affected by three factors: adverse selection, moral hazard and costly monitoring (Walsh, 2003).
Adverse selection stresses the heterogeneity of borrowers and how this combined with imperfect information has an impact on credit markets. If two types of borrowers are considered with differing probabilities of repayment, for example Type G (probability of repayment: qg) and Type B (probability of repayment: qb). Now, if the lender knew what type of borrower he was dealing with, he would offer them customized interest rates: r/qg for Type Gs and r/qb > r/qg for Type Bs. However, if lenders do not have access to information about the type of borrower they are dealing with, then the terms of the loan determine what type of borrower the lender attracts. The lender might be faced with lower expected returns as a result of increases in the loan interest rate (which would cause increase in Type B borrowers), and this phenomenon is known as adverse selection. If the loan rate continues to increase, the lender’s returns and profits would decrease even though there would still be more demand than supply of loans (Walsh, 2003)
Moral hazard differs from adverse selection because while in the latter the changes in loan terms attracted borrowers with different characteristics, moral hazard occurs when the borrowers have a choice between projects of varying risks, and lenders can not monitor this choice. Hence, if the lender offers higher loan rates, his higher expected return is not guaranteed because the higher rates may cause the borrower to make riskier investments, which would cause the lender’s expected return to decline. Walsh (2003) discusses a model in which the borrower has two project options to invest in: A, which has a payoff of Ra and 0 in good and bad states respectively, and B, which has a payoff of Rb>Ra and 0 in the good and bad states respectively. The probability of success for both is: A: pa and B: pb, where pa > pb. B is the riskier of the two projects and the expected payoff is higher from A as pa Ra > pb Rb. L is the loan amount, rl is the interest rate on the loan and C is the collateral the lender requires.
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Therefore, if the borrower invests in A, his expected return would be:
EA = pa [Ra – (1 + rl )L] – (1 – pa ) C,
And if the project fails, the borrower would end up losing his collateral, C. The same way, the expected return from Project B is:
EB = pb [Rb – (1 + rl )L] – (1 – pb ) C.
Since the expected returns on A and B are determined by the rl , the interest rate on the loan, it only follows that EA would be higher than EB, but this will only hold true if:
[(paRa – pbRb) / (pa – pb)] > (1 + rl ) L – C
The above equation shows that while the loan rate does not influence the left side, it does cause the right side to increase as rl increases. If we introduce rl* as the loan rate which would equate the expected returns to borrowers from A and B, then:
(1 + rl ) L – C = [(paRa – pbRb) / (pa – pb)]
If the loan rates are lower than rl* the borrower will choose project A but if they are higher than rl*, the borrower will opt for the riskier option of the two, B. The lender’s payment will hence be:
Pa(1+ rl)L + (1 – pa) C if rl < rl* and Pb(1+ rl)L + (1 – pb) C if rl > rl*.
Hence, the conclusion is that the lender’s profits are not a blind function of the loan rate and if the loan rate rises above rl*, his profits will decline, therefore, the possibility for credit rationing as a means to bring equilibrium to the credit market, similar to the case of adverse selection (Walsh, 2003).
Lastly, monitoring costs are the costs lenders incur to monitor borrowers, which can lead to credit rationing and debt contracts even if the above two scenarios of adverse selection and moral hazard are not present. Walsh (2003) presents a scenario where the lender has to incur a positive cost to observe the borrower’s project result, and this cost has to be incurred because any repayment schedule that links the borrower’s payment to the outcome of the project deems it necessary. If this is not done, the borrower can easily present an inaccurate report of the project outcome. Hence, if monitoring costs are taken into consideration, then as Walsh (2003) states, they can “account for both the general form of loan contracts in which monitoring occurs only when the borrower defaults – in which case the lender takes over the entire project’s return – and for rationing to arise in some equilibria.”
Bernanke, Ben S., & Gertler, Mark. Inside the Black Box: The Credit Channel of Monetary Policy Transmission. Journal of Economic Perspectives 9.4 (1995): 27-48.
Walsh, Carl E. Monetary Theory and Policy. Cambridge: MIT Press, 1998.