EUROPEAN MONETARY POLICY IN CRISIS TIMES: New evidence on the interest rate channel

The interest rate channel through which monetary policy is transmitted to the wider economy never entirely broke down, even at the height of the Eurozone crisis. That is the central conclusion of research by Gonzalo Camba-Mendez, Alain Durre and Francesco Paolo Mongelli, to be presented at the Royal Economic Society''s annual conference in Brighton in March 2016. Their study explores how financial tensions are ultimately reflected in banks'' pricing and lending policies.

The financial crisis that started in August 2007 challenged monetary policy strategies around the world. In fact, the European Central Bank (ECB) has been in ''crisis-mode'' ever since. The crisis morphed from a liquidity crisis into a solvency crisis in September 2008, which was then followed by the Great Recession. Thereafter, in May 2010, the sovereign debt crisis of the euro area erupted, halting a long period of low and homogeneous financing costs. Euro area countries were no longer treated equally in terms of sovereign risks. Some countries suffered from ''doom-loops''.

In the euro area a dramatic display of this mutating crisis were tensions in several financial market segments – namely money markets, corporate bond markets and debt markets – which posed a financing risk to banks. This endangered the transmission of the single monetary policy along the yield curve and threatened the anchoring role of policy interest rates (on the ECB''s main refinancing operations, and deposit and lending facilities).

Despite the richness of research on the financial crisis – as well as the effects of standard and non-standard monetary policies – we still do not know enough how the interest rate channel performed under such difficult circumstances.

How did banks cope for more than eight years with impaired balance sheets? Downgraded sovereign bonds and deteriorating loan portfolios, weakened banks assets holdings (''doom-loops''). On the liabilities side, banks were also severely impaired in their financing, especially in stressed euro area countries.

This study presents a new theoretical model illustrating how financing tensions are reflected in banks'' interest rate-setting. This makes it possible to shed light on how financial tension were ultimately reflected in banks'' pricing and lending policies, and thereby a reflected the functioning of the interest rate channel.

The original contribution is threefold:

First, the authors present a theoretical model in which bond issuance is set endogenously, and banks can either issue or buy bonds.

Second, the model also captures non-linearities between banks'' risk-aversion and risk compensation. These innovations in the model yield a more accurate picture about how financing tensions are reflected in banks interest rate setting, and thus the working of the interest rate channel.

Third, the researchers test whether the strength and speed of the interest pass-through depends on banks'' business model – fixed versus floating funding – plus the financing tensions. They find that this was indeed the case. Throughout the crisis – even when euro break-up risks peaked in 2011 and mid-2012 – the interest rate channel never entirely broke down: that is, the umbilical cord of the economic and financial system resisted.