Working PaPer SerieS
no 1150 / January 2010
Do bank loanS
anD creDit
StanDarDS have
an effect on
outPut?
a Panel
aPProach for
the euro area
by Lorenzo Cappiello,
Arjan Kadareja,
Christoffer Kok S胸rensen
and Marco Protopapa

---

W O R K I N G PA P E R S E R I E S
N O 115 0 / J A N U A R Y 2 010
DO BANK LOANS AND
CREDIT STANDARDS HAVE
AN EFFECT ON OUTPUT?
A PANEL APPROACH
FOR THE EURO AREA 1
by Lorenzo Cappiello 2, Arjan Kadareja 3,
Christoffer Kok Sørensen 2 and
Marco Protopapa 2
In 2010 all ECB
This paper can be downloaded without charge from
publications
feature a motif
http://www.ecb.europa.eu or from the Social Science Research Network
taken from the
€500 banknote.
electronic library at http://ssrn.com/abstract_id=1535995.
1 We are indebted to Francesco Drudi and Manfred Kremer for valuable comments and discussions. We would also like to thank an anonymous
referee for providing helpful comments. Of course, remaining errors are ours alone. The views expressed in this paper are those of the
authors and do not necessarily reflect those of the European Central Bank or the Eurosystem.
2 European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany. Corresponding author: Lorenzo Cappiello;
e-mail: lorenzo.cappiello@ecb.int; tel.: +49 69 1344 8765.
3 Bank of Albania, Sheshi “Skënderbej”, No.1 Tirana, Albania; e-mail: kadareja@yahoo.com

---

© European Central Bank, 2010
Address
Kaiserstrasse 29
60311 Frankfurt am Main, Germany
Postal address
Postfach 16 03 19
60066 Frankfurt am Main, Germany
Telephone
+49 69 1344 0
Website
http://www.ecb.europa.eu
Fax
+49 69 1344 6000
All rights reserved.
Any reproduction, publication and
reprint in the form of a different
publication, whether printed or
produced electronically, in whole or in
part, is permitted only with the explicit
written authorisation of the ECB or the
author(s).
The views expressed in this paper do not
necessarily refl ect those of the European
Central Bank.
Information on all of the working papers
published in the ECB’s Working Paper
Series can be found on the ECB’s website,
http://www.ecb.europa.eu/pub/scientifi c/
wps/date/html/index.en.html
ISSN 1725-2806 (online)

---

CONTENTS
Abstract
4
Non-technical summary
5
1 Introduction
7
2 A model on the banking lending channel
10
3 Data
14
4 Empirical methodology and results
15
5 Discussion
16
6 Conclusion
18
References
20
Figures and Tables 23
ECB
Working Paper Series No 1150
January 2010
3

---

Abstract
Applying the identi…cation strategy employed by Driscoll (2004) for the United
States, this paper provides empirical evidence for the existence of a bank lending
channel of monetary policy transmission in the euro area. In addition, and in
contrast to recent …ndings for the US, we …nd that in the euro area changes in
the supply of credit, both in terms of volumes and in terms of credit standards
applied on loans to enterprises, have signi…cant e¤ects on real economic activity.
This highlights the importance of the monitoring of credit developments in the
toolkit of monetary policy and underpins the reasoning behind giving monetary
and credit analysis a prominent role in the monetary policy strategy of the ECB.
It also points to the potential negative repercussions on real economic growth
of bank balance sheet impairments arising in the context of the …nancial crisis
erupting in mid-2007 which led to the need for banks to delever their balance
sheets and possibly to reduce their loan supply.
Keywords: bank credit, bank lending channel, euro area, panel data
JEL classi…cation: C23, E51, E52, G21
ECB
4
Working Paper Series No 1150
January 2010

---

Non-technical Summary
The …nancial crisis which erupted in mid-2007 implied substantial impairments to euro
area banks’balance sheets and their access to wholesale funding. This development
raised concerns about the possible impact on banks’ ability to provide lending to
households and …rms. Owing to the predominant position of the banking sector in the
euro area …nancial system an impaired provision of credit by banks could have severe
ampli…cations on real economic activity and in‡ation. The monetary policy actions
taken by the ECB (and other central banks) since the …nancial turmoil surfaced,
inter alia in the form of substantial reductions in key policy rates and the provision
of unlimited liquidity to the banking sector, to a large extent aimed at alleviating the
negative repercussions on credit supply of the balance sheet constraints that banks
faced during this period.
The e¤ectiveness of policy actions seeking to support a continued provision of
credit to the non-…nancial private sector relies on an in-depth understanding of the
links between monetary policy, credit supply and economic activity. Against this
background, this paper evaluates the e¤ects of changes in credit supply on output for
the euro area. The analysis is carried out from the perspective of the bank lending
channel, thereby addressing two related questions: …rst, whether a change in banks’
…nancing cost has an e¤ect on loan supply and, second, whether changes in banks’
loans have an impact on output. The answer to these questions is based on two
assumptions. The …rst one concerns the “special” status that deposits have in the
liability structure of banks, in that deposits cannot be perfectly substituted with
other forms of funding; a particularly realistic hypothesis at the current juncture.
The second assumption regards the peculiarity of loans for …rms (and households),
in the sense that companies (and consumers) cannot perfectly substitute loans with
bonds or equities.
When evaluating the impact of credit growth on output there are a number of
issues that need to be addressed. One of the most pertinent issues concerns the en-
dogeneity, or reverse causality, problem, since one cannot distinguish whether loan
supply a¤ects output or, vice versa, if the demand for (and supply of) loans is deter-
mined by future expected output. This issue is addressed by adopting a model à la
Driscoll (2004). This framework exploits a key insight whereby euro area countries
are viewed as a group of small open economies under a …xed exchange rate regime
with nationally segmented retail banking markets. Therefore, country-speci…c shocks
to money demand will lead to country-speci…c variations in the supply of loans. For
instance, suppose that, for a given level of output and interest rate, there is a posi-
tive money demand shock in any one of the euro area member states. If households
ECB
Working Paper Series No 1150
January 2010
5

---

and …rms desire to hold more money, deposits will increase. As a consequence, since
exchange rates are irrevocably …xed, real balances should go up in the country which
has experienced the money demand shock and slightly decrease everywhere else. If
the lending channel plays a role, the deposit growth should lead to an increase in the
supply of loans due to the additional source of …nancing for banks. Therefore, output
should also increase assuming the imperfect substitutability between bank loans and
other sources of …nancing for …rms and households.
In line with the above discussion, since country-speci…c money demand shocks
are correlated with loan supply but not with output and loan demand disturbances,
they are a good instrument that can be used in the regression of output on loans and
identify unambiguously the causal relationship from loans to GDP growth. The use
of these instrumental variables has the additional advantage that the ECB cannot
smooth country-speci…c shocks due to the common monetary policy and the “…xed-
exchange rate regime” among member states.
The estimation strategy, based on pooled regressions, involves three steps, and
all the variables employed in the regressions are constructed as deviations from their
cross-sectional mean values. First, output growth is regressed on the growth rate
of bank loans to investigate whether there is a positive and signi…cant relationship
between these two variables (albeit, at this stage, without addressing the endogene-
ity issue). In the second step, in order to retrieve money demand shocks, for each
country a money demand function is estimated. Moreover, bank loans are regressed
on these shocks to verify whether they are good instruments for loans. Third, output
is regressed on loans instrumented with money demand shocks.
Our results provide empirical evidence for the existence of a bank lending channel
of monetary policy transmission in the euro area. In addition, and in contrast to
recent …ndings for the US, we …nd that in the euro area changes in the supply of
credit, both in terms of volumes and in terms of credit standards applied on loans
to enterprises, have signi…cant e¤ects on real economic activity. In other words, a
change in loan growth has a positive and statistically signi…cant e¤ect on GDP. This
highlights the importance of including the monitoring of credit developments in the
toolkit of monetary policy and underpins the reasoning behind giving monetary and
credit analysis a prominent role in the monetary policy strategy of the ECB. These
…ndings furthermore point to the potential negative repercussions on real economic
growth arising from the …nancial crisis that erupted in mid-2007 and which resulted
in serious impairments of euro area banks’balance sheets and the need for banks to
delever and possibly to reduce their supply of loans.
ECB
6
Working Paper Series No 1150
January 2010

---

1
Introduction
The …nancial crisis which surfaced in August 2007 has highlighted the vulnerability
of …nancial intermediaries, and more speci…cally of the banking system, at least along
two interrelated dimensions. On the one hand, faced with the risk of insolvency due to
the erosion of their capital base after heavy losses, banks have been in need of raising
fresh capital, whether through private investors or government aid programmes. On
the other hand, banks have experienced di¢ culties in raising funds at medium and
long-term as well as at short-term: inter alia, spreads on bank bonds increased to
unprecedented levels, while Libor-OIS spreads in the inter-bank money markets also
reached historical peaks, especially following the demise of Lehman Brothers, the US
investment bank, in September 2008. Moreover, banks’ability to securitise their loans
and transfer credit risk o¤ their balance sheet was seriously disrupted adding further
strains on their access to funding. The mounting woes of the banking system implied
a signi…cant pressure on banks to contract their balance sheets and, ultimately, in a
reduction of credit. For example, according to the IMF (2009), the write-downs on
securitised assets and charge-o¤s on banks’loan books could result in a disorderly de-
leveraging scenario through which without further capital injections from governments
and private investors, the credit growth could shrink signi…cantly. Indeed, in the
euro area, the ‡ows of credit to non-…nancial corporations and households began to
signi…cantly abate towards the end of 2008, which apart from the typical demand-
driven reaction to a downturn in the business cycle might to some extent also derive
from problems related directly to banks’capital positions and their access to funding.
For example, the results of the ECB bank lending survey have pointed toward a
combination of demand-side and supply-side factors contributing to the deceleration
of the growth rate of loans to households and …rms in the euro area.1 Moreover, since
the euro area …nancial system is relatively bank-centred compared, for instance, to
the United States, it is relevant to assess whether there exists a signi…cant relation
between bank loans extended to the non-…nancial private sector and real activity.
From a monetary policy viewpoint, the di¢ culties related to bank balance sheets
arising in the context of the …nancial crisis have raised concerns about the e¤ective-
ness with which monetary policy decisions are transmitted to the real side of the
economy via its impact on banking sector conditions. Monetary policy may a¤ect
real economic activity, and ultimately in‡ation, via its impact on the banking sector
through a number of transmission channels.2 One transmission channel a¤ected by
1 See e.g. Hempell and Kok Sørensen (2009).
2 For early contributions acknowledging the importance of banks in the monetary policy transmis-
sion mechanism, see Brunner and Meltzer (1963) and Bernanke (1983). See also ECB (2008b) for a
ECB
Working Paper Series No 1150
January 2010
7

---

bank behaviour is the degree and speed with which banks pass on changes in policy
rates (“interest rate channel”). 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 depend among other things on the …nan-
cial structure and the degree of competition within the banking sector as well as on
competition from market-based sources.3 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 and eventually on economic activity and in‡ation.
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”).4 Monetary policy via its e¤ect on the cash ‡ows of
potential borrowers and on the value of their collateral may likewise in‡uence the
creditworthiness of bank borrowers leading to a change in their external …nancing
premium charged by the banks. This, in turn, may induce banks to alter their supply
of loans to these borrowers (the “broad credit channel”).5 Furthermore, bank credit
has also been shown to be related to the boom and bust of economic cycles, for exam-
ple as evidenced by the correlation between credit cycles and assets cycles. The latter
fact is related to what has recently been labelled the “risk-taking” channel of mone-
tary policy. This channel builds on the notion that monetary policy may amplify the
procyclical nature of bank (and non-bank) intermediation through the impact it may
have on the pricing, management and perception of risk by …nancial intermediaries.6
All in all, the fact that monetary policy can a¤ect the balance sheets of banks and
detailed description of the role of banks in the monetary policy transmission mechanim.
3 See e.g. Gropp et al. (2007) and Van Leuvensteijn et al. (2008).
4 See Bernanke and Blinder (1988), Bernanke and Gertler (1995), Peek and Rosengren (1995),
Kashyap and Stein (2000), Van den Heuvel (2002) and Kishan and Opiela (2006) for some of the
early contributions to this line of the literature. For the euro area Ehrmann et al. (2001) provided
some evidence of the existence of a bank lending channel working mainly via bank liquidity positions;
see also Angeloni, Kashyap and Mojon (2003) for early euro area evidence. Moreover, Gambacorta
and Mistrulli (2004) and Altunbas et al. (2004) provide evidence of the importance of bank capital
positions in the bank lending channel. More recently, Altunbas et al. (2008) point to the impact of
securitisation, bank risk, capital and liquidity positions on monetary policy transmission.
5 See Bernanke et al. (1999) for the seminal contribution on the balance sheet channel of monetary
policy transmission.
6 See e.g. Rajan (2005) and Borio and Zhu (2008). For recent empirical evidence of the risk-taking
channel in a European context see Jiménez et al. (2007), Maddaloni et al. (2009), Altunbas et al.
(2009), Ioannidou et al. (2009).
ECB
8
Working Paper Series No 1150
January 2010

---

their borrowers may amplify the impact of monetary policy on the wider economy.
Whereas, as mentioned above, several studies …nd evidence of the importance of
the bank lending channel in the sense that monetary policy impacts on bank credit
supply, it cannot be taken for granted that such changes in credit supply in turn have
signi…cant e¤ects on real economic activity. Indeed, for the US neither Driscoll (2004)
nor Ashcraft (2006) …nd compelling evidence for a strong causal relationship between
credit supply and real output.
However, owing to the central role bank …nancing plays in the euro area …nancial
system, in this paper we set out to examine whether, in contrast to US …ndings,
changes in credit supply have signi…cant e¤ects on real activity in the euro area.
Following Driscoll (2004), using a panel econometric methodology we approach the
issue from the perspective of the bank lending channel, thereby addressing two related
questions: …rst, whether a change in banks’funding has an e¤ect on loan supply and,
second, whether changes in banks’ loans have an impact on output. The answer to
these questions is based on two assumptions. The …rst one concerns the “special”
status that (non-interbank) deposits have in the liability structure of banks, in that
deposits cannot be perfectly substituted with other forms of funding; a particularly
realistic hypothesis at the current juncture.7
That is, in this paper we build on
the notion of imperfect substitutatibility between deposits and other sources of bank
funding as a prerequisite for the bank lending channel to exist. Hence, to the extent
that a change in the policy rate a¤ect the money-holding sector’s demand for bank
deposits, banks may not be able to perfectly adjust their funding structure and as a
result they may have to alter the composition of their assets. At the same time, our
identi…cation does not rely on the textbook notion that the central bank explicitly
can a¤ect the volume of bank reserves, which we would argue does not correspond
to the way monetary policy is implemented in practice.8 The second assumption
regards the peculiarity of loans for …rms (and households), in the sense that companies
(and consumers) cannot perfectly substitute loans with other forms of …nance, such
as bonds or equities. This may be particularly pertinent in the case of the euro
area where bank …nancing is the predominant means of …nancing for non-…nancial
corporations.
For example, by the end of 2007 bank loans to the private sector
7 In the euro area banking sector balance sheet, deposits taken from the non-…nancial sector con-
stitute around one-third of total liabilities and thus is the most important source of bank funding.
8 Many macroeconomic textbooks describing the traditional bank lending channel adhere to the
central bank’s ability to directly control the quantity of bank reserves through binding reserve require-
ments, which in turn should limit the banking sector’s ability to issue demand deposits. However,
as for example pointed out by Diyatat (2008), this view is at odds with how monetary policy is
conducted in practice. In fact, in modern central banking there is a decoupling of the short-term
interest rate set by the central bank and the reserve balances; see also Borio and Diyatat (2009).
ECB
Working Paper Series No 1150
January 2010
9

---

Document Outline

• Do bank loans and credit standards have an effect on output? A panel approach for the euro area
• Contents
• Abstract
• Non-technical Summary
• 1 Introduction
• 2 A model on the banking lending channel
• 3 Data
• 4 Empirical methodology and results
• 5 Discussion
• 6 Conclusion
• References
• Figures and Tables

---