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Bank core deposits and the mitigation of monetary policy

  • Lamont Black
  • Diana Hancock
  • Wayne Passmore
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    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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    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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    1. Mitchell A. Petersen & Raghuram G. Rajan, 1994. "The Effect of Credit Market Competition on Lending Relationships," NBER Working Papers 4921, National Bureau of Economic Research, Inc.
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    10. 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.
    11. Berlin, Mitchell & Mester, Loretta J, 1999. "Deposits and Relationship Lending," Review of Financial Studies, Society for Financial Studies, vol. 12(3), pages 579-607.
    12. 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.).
    13. Gambacorta, Leonardo, 2005. "Inside the bank lending channel," European Economic Review, Elsevier, vol. 49(7), pages 1737-1759, October.
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