The global financial crisis has caused substantial damage to Eurozone banks’ balance sheets and their access to funding, raising concerns about the knock-on effects on households and firms. Because Eurzone banks are central to both the financial system and the provision of funds to the real economy, a reduction in credit offered by banks could have severe ramifications for the real economy.
To put the importance of the banking sector in the Eurozone into perspective, by the end of 2007 bank loans to the private sector made up 145% of Eurozone GDP, compared with 63% in the US (ECB 2009a). Furthermore, bank-dependent firms should normally be found among the small- and medium-sized enterprises (SME) that are not able to raise funds in the capital markets. Sixty-seven percent of employed people are in the SME sector in the Eurozone, which is substantially larger than the 43% in the US.1 For these reasons, the large drop in the growth of bank loans to non-financial corporations observed in recent months (see Figure 1) deserves close monitoring by policymakers. Although the decline in overall lending to non-financial corporations at the Eurozone level appears to be mostly linked to demand factors, it cannot be ruled out that developments are to a certain extent also driven by supply-side constraints in the banking sector (ECB 2009b).
Figure 1. Real annual growth rates of GDP and loans to non-financial corporations in the Eurozone (%)
Source: ECB and Eurostat.
New insight on the effect of credit supply in the Eurozone
In a recent paper (Cappiello et al. 2010), we evaluate the effects of changes in credit supply on output for the Eurozone. Our analysis is carried out from the perspective of the bank lending channel of monetary policy transmission, thereby addressing two related questions: first, whether a change in banks’ financing cost has an effect 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 first one concerns the “special” status of deposits 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 firms, in the sense that companies cannot perfectly substitute loans with other sources of finance – this is likely to hold true given the large population of Eurozone SMEs.
Evaluating the effect of credit growth on output raises a number of issues. One of the most pertinent is concerning endogeneity, or reverse causality, since it is not possible to perfectly distinguish whether loan supply affects output or if the demand for (and supply of) loans is determined by future expected output. Following Driscoll (2004), our paper addresses this issue by considering the Eurozone countries as a group of small open economies under a fixed exchange rate regime with nationally segmented retail banking markets. Therefore, country-specific shocks to money demand will lead to country-specific variations in the supply of loans. For instance, suppose that, for a given level of output and interest rate, there is a positive money demand shock in any one of the Eurozone member states. If households and firms desire to hold more money, deposits will increase. As a consequence, since exchange rates are irrevocably fixed, 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 financing for banks. Therefore, output should also increase assuming the imperfect substitutability between bank loans and other sources of financing for firms and households.
Our results provide empirical evidence for the existence of a bank lending channel of monetary policy transmission in the Eurozone. In addition, and in contrast to recent findings for the US (Driscoll 2004), it is found that in the Eurozone changes in the supply of credit, both in terms of volumes and in terms of credit standards applied on loans to enterprises, have significant effects on real economic activity. In other words, a change in loan availability has a positive and statistically significant effect on GDP.
These findings point to the potential negative repercussions on real economic growth arising from the effect of the financial crisis on Eurozone banks’ balance sheet. That being said, the rebound in debt securities financing by Eurozone non-financial corporations observed in the past year may have somewhat mitigated the otherwise adverse macroeconomic implications from the slowdown in bank lending. Finally, the results also provide support for the different policy measures taken by the major central banks to mitigate the real economic effects of the financial crisis; with those of the Eurosystem focusing in particular on alleviating the pressures on the banking system, whereas policy measures in the US have focused more on supporting market-based financing.
Disclaimer: The views expressed are those of the authors and do not necessarily represent those of the European Central Bank, the Eurosystem, the Bank of Albania, the European University of Tirana or the University of New York at Tirana (Albania).
1 According to figures from the European Commission (for the year 2008) and the US Census Bureau (for the year 2004).
Cappiello, Lorenzo, Arjan Kadareja, Christoffer Kok Sørensen, and Marco Protopapa (2010), “Do bank loans and credit standards have an effect on output? A panel approach for the euro area”, ECB Working Paper 1150, January.
Driscoll, John C (2004), “Does bank lending affect output? Evidence from the US States”, Journal of Monetary Economics, (51):451-77.
ECB (2009a), “The external financing of households and non-financial corporations: A comparison between the euro area and the United States”, ECB Monthly Bulletin, April.
ECB (2009b),”Monetary policy and loan supply in the euro area”, ECB Monthly Bulletin, October.