Scientific Monographs, Bank of Finland
Effects of moral hazard and monitoring on monetary policy transmission
Abstract: This study discusses the effects of financial
intermediation, banks’ moral hazard and monitoring on monetary policy
transmission in a simple model where borrowers are dependent on loans
granted by banks with superior monitoring skills. As distinct from the
prior literature on monetary policy transmission, this study does not
regard banks' deposit funding as a reason for their special role in the
monetary transmission. Instead, we focus on banks’ role in monitoring their
loan customers as part of financial intermediation and on the effects of
monitoring on monetary policy.
We find that when the intensity of
monitoring is endogenous banks acting as financial intermediaries with
moral hazard problems respond less to monetary policy in lending than
nonintermediary lenders that only lend their own capital without moral
hazard problems. We also find that in the model the lending response of
intermediary banks to monetary policy depends on the ratio of their own
capital to the volume of lending. The finding is fairly insensitive to the
market structure of the banking sector. In the case of a monopoly bank, an
increase in the bank's capital-to-loans ratio always weakens the
transmission of monetary policy to bank lending. In the case of competitive
banks, an increase in the capital-to-loans ratio weakens the transmission
of monetary policy to aggregate bank lending, up to a critical level.
Using a data set covering the Finnish banking sector in 1995–2000, we also
offer some tentative empirical evidence that is broadly consistent with the
model. Banks with higher capital ratios tend to respond less to changes in
monetary policy. Our conclusion is that the outcome of the model might be
helpful in explaining the heterogeneity of banks’ responses to monetary
policy, which frequently observed in the empirical literature.
Keywords: monetary policy transmission; monitoring; moral hazard; bank lending channel; (follow links to similar papers)
JEL-Codes: E51; E52; G21; (follow links to similar papers)
150 pages, January 1, 2003
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