The transmission channels between the financial and real sectors: a critical survey of the literature

Understanding the transmission channels that exist between the financial and real sectors of the economy is critically important when assessing financial stability. Robust financial systems are viewed as those that do not adversely induce the propagation and amplification of disturbances that affect the financial system and those that are capable of withstanding shocks and limiting disruptions in the allocation of savings to profitable investment opportunities. Most definitions of financial stability and the "macroprudential approach" to financial supervision recently advocated by many financial stability bodies emphasise the macroeconomic consequences of disruptions to the functioning of the financial system. This paper presents a review of the literature on the transmission channels between the financial and the real sectors, as well as observations regarding aspects of the transmission channels that remain inadequately addressed by the existing literature. The paper identifies three transmission channels that exist between the financial and the real sector: (i) the borrower balance sheet channel; (ii) the bank balance sheet channel; and (iii) the liquidity channel. The first two channels are often referred to as the financial accelerator channel; the third channel emphasises the liquidity position of banks' balance sheets, whose interest has been fairly recent - in part, spurred on by the current crisis. A report reflecting some of the findings of this literature, as well as other analysis within the Basel Committee, will be published in the future.