Working Paper: NBER ID: w22141
Authors: Johannes F. Wieland; Mujeung Yang
Abstract: We propose a novel mechanism, “financial dampening,” whereby loan retrenchment by banks attenuates the effectiveness of monetary policy. The theory unifies an endogenous supply of illiquid local loans and risk-sharing among subsidiaries of bank holding companies (BHCs). We derive an IV-strategy that separates supply-driven loan retrenchment from local loan demand, by exploiting linkages through BHC-internal capital markets across spatially-separate BHC member-banks. We estimate that retrenching banks increase loan supply substantially less in response to exogenous monetary policy rate reductions. This relative decline has persistent effects on local employment and thus provides a rationale for slow recoveries from financial distress.
Keywords: Monetary Policy; Financial Crises; Loan Retrenchment; Banking; Economic Recovery
JEL Codes: E5; E50; E51; E52; G20; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Loan retrenchment by banks (G21) | Effectiveness of monetary policy (E52) |
| Retrenching banks (G21) | Loan supply response to monetary policy rate reductions (E51) |
| Loan supply response to monetary policy rate reductions (E51) | Local employment growth (J69) |
| Loan retrenchment by banks (G21) | Local employment growth (J69) |