Financial fragmentation and the monetary transmission mechanism in the euro area: a smooth transition VAR approach

Abstract

This paper investigates the effect of financial fragmentation on the monetary transmission mechanism in different Euro area economies, categorized into two groups: countries considered as “core” economies and countries characterized as “peripheral” economies. We analyze the effects of financial fragmentation on the monetary transmission mechanism through the traditional interest rate channel. To gauge the impact of changes in policy rates on the behavior of real variables such as aggregate output and employment we use a Smooth Transition VAR (VSTAR) model. Employing a nonlinear multivariate time series approach helps us capture the regime-dependent dynamics of the variables under study. The results obtained show that money market rates targeted by the central bank do not completely pass through to banks’ lending rates to firms, particularly in a financially fragmented environment. This finding supports the hypothesis of an impairment of the monetary transmission mechanism as a result of financial fragmentation. Given this impairment in some sectors and regions an accompanying credit volume policy might have been appropriate.

Business cycles, financial conditions, and nonlinearities

“…Notice that if Z * and d are known then the TVAR is simply two VAR models defined over the respective samples using T t ≤ Z * and T t > Z * . 15 Schleer and Semmler (2015) also confirmed the relevance of nonlinearities in the relationship between the financial sector and industrial production indeces for countries in the Euro area and provided further evidence of amplification effects of financial sector shocks over time; while Kotz et al (2018) investigated the effects of changes in policy interest rates on the behavior of real variables, also demonstrating evidence of regime-dependent dynamics in aggregate output and employment. Nevertheless, they employed Smooth Transition Vector Autoregression models and their research interests are, again, different from ours.…”

“…Ferraresi et al (2015) focused on how the state of credit markets affects the impact of fiscal policies in the USA, showing that fiscal multipliers are abundantly and persistently higher than one when firms face increasing financing costs and they are feebler and lower than one in the "normal" credit regime. 7 Regarding countries in the Euro area, Schleer and Semmler (2015) confirmed the relevance of nonlinearities in the relationship between the financial sector and industrial production indeces and provided further evidence of amplification effects of financial sector shocks over time; while Kotz et al (2018) investigated the effects of changes in policy interest rates on the behavior of real variables, also demonstrating evidence of regime-dependent dynamics in aggregate output and employment. To the best of our knowledge, the only papers that have tried to consider the possible nonlinear effects of financial conditions on investment activity are panel data studies at the micro level that used sample-splitting techniques, such as Fazzari et al (1988) and Whited (1992), who found evidence that the composition of corporate finance is an important determinant of firms' investment activity, and that small or new firms are most likely to be financially constrained and most sensitive to the availability of internal finance.…”

European economic, fiscal, and social policy at the crossroads

“…This latter hypothesis might be doubtful since a fully integrated capital market does not seem to be less vulnerable against financial market shocks and contagion effects, as the great recession starting in the US 2008/9 has shown. One might argue on the contrary, as in Kotz, Tahri, and Semmler (2018) that a diverse capital market in Europe with a variety of different financial institutions might be a good buffer against the contagion effects of financial shocks. b.…”