This paper investigates how business cycle volatility affects internal and external funding sources of banks. It argues that excessive credit growth, credit cycles, and bank failures are phenomena related to distinct patterns of banks' financing options over the cycle. This perspective reconciles rational behavior with some implications of Minsky's financial instability hypothesis.
We analyse the effects of policy measures to stop the fall in loan supply following a banking crisis. We apply a dynamic framework in which a debt overhang induces banks to curtail lending or choose a fragile capital structure. Government assistance conditional on new banking activities, like on new lending or on debt and equity issues, allow banks to influence the scale of assistance and externalise risks, implying overinvestment or excessive risk taking or both. Assistance without reference to new activities, like granting lump sum transfers or establishing bad banks, does not generate adverse incentives, but may have higher fiscal costs.
We analyse the impact of overnight interbank market frictions on bank loan supply when banks face idiosyncratic liquidity risk and discuss resulting implications for monetary policy implementation. Sufficiently pronounced interbank market frictions imply that banks hold positive or negative precautionary liquidity. Holding positive (negative) precautionary liquidity means that banks hold more (less) liquidity than they expect to need. As holding precautionary liquidity is costly, interbank market frictions negatively influence bank loan supply. However, by means of its standing facilities, the central bank not only offers an alternative to using the interbank market but also determines the costs of friction-induced holdings of positive or negative precautionary liquidity. Therefore, the facilities allow the central bank to influence banks' expected liquidity costs, and thereby their loan supply, so that interbank market frictions need not be an impediment to monetary policy transmission.
This paper develops a theoretical model which replicates main institutional features of the euro overnight interbank market and the Eurosystem's operational framework which has been in place since September 2008. Main ingredients of the model are frictions in form of participation costs in the interbank market, a refinancing operation with unlimited liquidity supply and two standing facilities offered by the central bank. The model can explain several stylized facts observed during the financial crisis as the decline in interbankborrowing and the interbank rate, the increased borrowing from the Eurosystem and the strong recourse to its deposit facility. Furthermore, we discuss some policy implications.
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