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Bank core deposits and the mitigation of monetary policy

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  • Lamont Black
  • Diana Hancock
  • Wayne Passmore
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    Abstract

    We consider the business strategy of some banks that provide relationship loans (where they have loan origination and monitoring advantages relative to capital markets) with core deposit funding (where they can pass along the benefit of a sticky price on deposits). These "traditional banks" tend to lend out less than the deposits they take in, so they have a "buffer stock" of core deposits. This buffer stock of core deposits can be used to mitigate the full effect of tighter monetary policy on their bank-dependent borrowers. In this manner, the business strategy of "traditional banks" acts as a "core deposit mitigation channel" to provide funds to bank-dependent borrowers when there are monetary shocks. In effect, there is no bank lending channel of monetary policy associated with these traditional banks. ; In contrast, other banks mainly rely on managed liabilities that are priced at market rates. These banks do not have to shift from insured deposits to managed liabilities in response to tighter monetary policy. At the margin, their loans are already funded with managed liabilities. For these banks as well, there is no unique bank lending channel of monetary policy. ; The only banks that are likely to raise loan rates substantially in response to an increase in the federal funds rate are banks with a high proportion of relationship loans that are close to a loan-to-core deposit ratio of one. These banks must substitute higher cost nondeposit liabilities, which have an external finance premium, for core deposits, which do not because of deposit insurance. Some of these banks may also face higher marginal costs as their loan-to-core deposit ratio approaches one because of the costs associated with lending to default-prone relationship borrowers. It is among these banks (which we refer to as high relationship lenders), and only these banks, that we find evidence of a bank lending channel - they significantly reduce lending in response to a monetary contraction. Importantly, these banks hold only a small fraction of U.S. banking assets. Thus, in the United States, the bank lending channel seems limited in scope and importance, mainly because so few banks that specialize in relationship lending switch from core deposits to managed liabilities in response to changes in interest rates.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2007-65.

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    Date of creation: 2007
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    Handle: RePEc:fip:fedgfe:2007-65

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    Keywords: Bank loans ; Banks and banking - United States;

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    References

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    1. Kishan, Ruby P. & Opiela, Timothy P., 2006. "Bank capital and loan asymmetry in the transmission of monetary policy," Journal of Banking & Finance, Elsevier, vol. 30(1), pages 259-285, January.
    2. Robert M. Adams & Dean F. Amel, 2005. "The effects of local banking market structure on the banking-lending channel of monetary policy," Finance and Economics Discussion Series 2005-16, Board of Governors of the Federal Reserve System (U.S.).
    3. David Neumark & Steven A. Sharpe, 1989. "Market structure and the nature of price rigidity: evidence from the market for consumer deposits," Finance and Economics Discussion Series 52, Board of Governors of the Federal Reserve System (U.S.).
    4. Douglas W. Diamond & Raghuram G. Rajan, 2006. "Money in a Theory of Banking," American Economic Review, American Economic Association, vol. 96(1), pages 30-53, March.
    5. Ben S. Bernanke & Ilian Mihov, 1995. "Measuring monetary policy," Working Papers in Applied Economic Theory 95-09, Federal Reserve Bank of San Francisco.
    6. Jayaratne, Jith & Morgan, Donald P, 2000. "Capital Market Frictions and Deposit Constraints at Banks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(1), pages 74-92, February.
    7. Charles Kahn & George Pennacchi & Ben Sopranzetti, 1999. "Bank Deposit Rate Clustering: Theory and Empirical Evidence," Journal of Finance, American Finance Association, vol. 54(6), pages 2185-2214, December.
    8. Anil K. Kashyap & Raghuram Rajan & Jeremy C. Stein, 1999. "Banks as Liquidity Providers: An Explanation for the Co-Existence of Lending and Deposit-Taking," NBER Working Papers 6962, National Bureau of Economic Research, Inc.
    9. Xavier Freixas & José Jorge, 2008. "The Role of Interbank Markets in Monetary Policy: A Model with Rationing," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(6), pages 1151-1176, 09.
    10. Gambacorta, Leonardo, 2005. "Inside the bank lending channel," European Economic Review, Elsevier, vol. 49(7), pages 1737-1759, October.
    11. Petersen, Mitchell A & Rajan, Raghuram G, 1995. "The Effect of Credit Market Competition on Lending Relationships," The Quarterly Journal of Economics, MIT Press, vol. 110(2), pages 407-43, May.
    12. Mitchell Berlin & Loretta J. Mester, 1997. "Deposits and relationship lending," Working Papers 96-18, Federal Reserve Bank of Philadelphia.
    13. Kishan, Ruby P & Opiela, Timothy P, 2000. "Bank Size, Bank Capital, and the Bank Lending Channel," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(1), pages 121-41, February.
    14. Skander Van den Heuvel, 2006. "The Bank Capital Channel of Monetary Policy," 2006 Meeting Papers 512, Society for Economic Dynamics.
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    Cited by:
    1. Carpenter, Seth & Demiralp, Selva, 2012. "Money, reserves, and the transmission of monetary policy: Does the money multiplier exist?," Journal of Macroeconomics, Elsevier, vol. 34(1), pages 59-75.
    2. Benjamin M. Tabak & Marcela T. Laiz & Daniel O. Cajueiro, 2010. "Financial Stability and Monetary Policy - The case of Brazil," Working Papers Series 217, Central Bank of Brazil, Research Department.
    3. Masami Imai, 2008. "Crowding-Out Effects of a Government-Owned Depository Institution: Evidence from a Natural Experiment in Japan," Wesleyan Economics Working Papers 2008-003, Wesleyan University, Department of Economics.
    4. Seth Carpenter & Selva Demiralp, 2009. "Money and the Transmission of Monetary Policy," Koç University-TUSIAD Economic Research Forum Working Papers 0906, Koc University-TUSIAD Economic Research Forum.

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