The impact of the financial crisis on the monetary transmission in the Eurozone

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BSc Thesis Economics and Business, specialization Economics and Finance

The impact of the Financial Crisis on the

monetary transmission in the Eurozone

Robert Wolters

10167226

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Abstract

This thesis will look at the effectiveness of monetary policy in the Eurozone during the financial crisis. First, the theory about the monetary transmission mechanism and its channels are explained. Given the fact that the European economy is bank-based, it is useful to look at the interest rate pass through and factors which will influence the completeness and the speed of this process. The findings of this paper suggest that the undercapitalization of banks and competition in the banking-market are important factors that influence the effectiveness of monetary policy.

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Introduction

Since the beginning of the financial crisis in the summer of 2008, there are many difficulties for monetary policy in the Euro area. In the aftermath of the financial crisis, the European Central Bank (ECB) lowered its policy rates to stimulate economic activity: lower interest rates makes it less attractive to save and more attractive to invest. In order to stimulate economic activity, the ECB used conventional tools such as open market operations. Besides that, the ECB implemented an unconventional program called “enhanced credit support”, which stretched the possibilities of existing conventional tools (Mishkin, Matthews, Giuliodori, 2013, chapter 15).

The monetary transmission mechanism describes the way in which the money market rates work (through different channels) on the retail interest rates, which are set by

commercial banks (ECB, 2000). This mechanism is important for central banks when

evaluating their monetary policy, because changes in the retail interest rates have an influence on the real economy: higher interest rates will stimulate economic agents to deposit more money and investing becomes more expensive (Belke, Beckmann & Verheyen, 2013). The various levels of interest rates have an impact on the channels of the MTM, such as the traditional interest rate channel and the credit channel. Since these channels explain the impact of monetary policy on investment and savings decisions, this mechanism can explain developments in economic growth and price level. The main goal of the ECB is price stability in the medium term, which is the reason why this mechanism is important in the evaluation of monetary policy (ECB, 2000).

There is a lot of research done on the monetary transmission mechanism in the euro area. However, there is not much research about the influence of the financial crisis. Therefore, this paper will discuss the implications of the recent financial crisis for the monetary transmission mechanism. The central research question is: Is monetary policy still effective during the financial crisis in the Euro area?

The first chapter will give an explanation of the different channels of monetary

transmission and the interest rate pass through. It will also explain the importance of banks for business-finance in the European economy. The second chapter will give a detailed

description of the factors explaining the completeness of the interest rate pass through, such as the competitiveness of the banking sector and the undercapitalization of banks. In the last

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chapter, I will take a look at empirical studies regarding structural breaks in the interest pass-through and I will analyze data on the monetary base, the M3-aggregate and credit spreads to investigate the functioning of the monetary transmission in the Eurozone.

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Chapter 1: The Monetary Transmission Mechanism (MTM) and its

channels

The monetary transmission mechanism describes the effect of monetary policy on the real economy. The main goal of the ECB is price stability in the medium term. The price level is affected by the state of the economy and vice versa. Therefore, it is useful for the ECB to evaluate monetary policy by looking at the most important transmission channels

(ECB,2000). In order to understand the mechanism, we will take a look at the tools of monetary policy, which are used by the ECB. Furthermore, I will explain the traditional interest rate channel, the credit channel, the balance-sheet channel and other-asset price channels. This will be followed by a discussion of the Taylor-rule and the Taylor principle. At the end of the chapter, I will look at the importance of banks for the European economy in comparison with the US and the implications for the monetary transmission mechanism.

Different channels: Which channels are described and in what way are these channels affected by the ECB?

The central bank has a set of conventional tools to conduct monetary policy. The first way is through the lending and deposit facilities: the so-called standing facilities (Mishkin,

Matthews, Giuliodori, 2013, chapter 15). The central bank can change the interest rates of the deposit and the lending facility as an instrument: if the central bank lowers the marginal lending facility rate, lending from the ECB becomes more attractive for commercial banks, especially when this interest rate is below the lending rate on the market. When the central bank lowers the deposit rate, commercial banks will get less interest on the deposited amount in comparison with the interest which can be earned on the market. Therefore, the opportunity cost for banks using the deposit facility of the ECB will increase.

The second way in which the ECB conducts monetary policy is through open market operations (Mishkin, Matthews, Giuliodori, 2013, chapter 15). This can be either a sale or a purchase: if the ECB conducts an open market purchase, the price of the assets purchased (mostly government securities) will increase, which will result in a lower rate of return on the asset. If the central banks conducts an open market sale, it is the other way around: the price of the assets decrease, which will increase the rate of return on the asset.

The most common way to conduct open market operations is through MROs: main refinancing operations (Mishkin, Matthews, Giuliodori, 2013, chapter 15). MROs are

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conducted on a weekly basis with a maturity of one week. These operations are conducted by the national central banks: they buy assets from credit institutions with the promise that the counterparty buys it back. Besides that, the national central bank can also provide a loan with assets as collateral. Although MROs are conducted by national central banks, the main refinancing rate is determined by the Governing Council of the ECB: it determines the minimum bid from credit institutions which will be accepted by the ECB. This process continues until the supplied reserves reach the desired level.

Moreover, the ECB can decide to undertake LTROs: longer-term refinancing

operations. These LTROs are conducted on a monthly basis with 3 months maturity. As stated by Mishkin, Matthews and Giuliodori (2013, chapter 15), these operations are used to provide liquidity to the banking sector. During the recent crises, the ECB extended the maturities and increased the amount. For example, during the sovereign debt crisis and its aftermath, the ECB conducted 3-year LTROs, which provided more than one trillion euros of liquidity to European credit institutions (Mishkin, Matthews, Giuliodori, 2013, chapter 15).

With knowledge of the tools of monetary policy, we can take a look at the different transmission channels of monetary policy. The traditional interest rate channel is most directly affected by open market operations (Mishkin, Matthews, Giuliodori, 2013, chapter 23). If the monetary policy is expansionary, the real interest rate decreases: the return on assets will go down as a consequence of the open market sale of the ECB. It will be less costly to invest during periods of low interest rates: this will cause the investment spending to increase, which has a positive impact on the economy.

While the earlier literature focused mainly on the interest rate channel, the modern literature emphasizes the importance of other channels. Modigliani (1971) wrote a theory about wealth effects, which is called “the life-cycle hypothesis of consumption”. The main insight of this theory is that consumers smooth their expenditures on non-durable goods and services over time. If the ECB conducts expansionary monetary policy, it will lead to higher stock and bond prices. When we assume consumers to hold either stock or bonds, the financial wealth of these consumers increase, with the result that the expenditures on non-durable goods and services will increase (Mishkin, Matthews, Giuliodori, 2013, chapter 23). Although the stockholdings in the Eurozone are not as widespread as in the US, wealth effects can play a similar role through bond-markets and other assets such as house prices (ECB, 2000).

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Other important channels , which follow from credit-market imperfections, are the credit channels (Bernanke, Gertler, 1995). Whereas the interest rate channel emphasizes the direct link between interest rates and investment spending, the credit view highlights the importance of asymmetric information problems. The underlying idea is that monetary policy does not only have an influence on interest rates, but also on the so-called "external-finance premium": this is the difference between the cost of external financing versus financing with retained earnings (Bernanke, Gertler, 1995). The first credit channel is the bank lending channel. This channel describes the effect of monetary policy on the quantity of loans supplied by banks. Expansionary monetary policy through MROs will increase the reserves held by banks: the amount of supplied reserves increases. Therefore, if the required reserves ratio remains the same, banks can supply more loans (Mishkin, Matthews, Giuliodori, 2013, chapter 23). This channel is especially important for smaller firms, since bank credit is the only source of finance for these firms, whereas bigger firms have the opportunity to raise capital through stock and bond markets (Mishin, Matthews, Giuliodori, 2013, chapter 23).

The second credit channel mentioned by Mishkin, Matthews and Guiliodori (2013, chapter 23) is the balance sheet channel, sometimes called the cost channel . The

expansionary monetary policy will cause the stock prices to rise, which will increase the net worth of the firm: the difference between assets and liabilities of the firm increase. If the firm participate in risky investments, the bank will fear that it will experience a loss on its loan to the company. With a higher net worth, the bank can make sure that it will get a substantial part of the loan back: if the company defaults on its debt, the bank can claim the net worth of the firm. Through a sale, the bank can compensate for its losses. Therefore, if the net worth increase, adverse selection and moral hazard problems will be less severe. As a result, bank-lending will increase, since there is less risk for the bank to issue a loan. This will increase the investment spending. The effect of this channel is limited for small firms, since these firms are not listed on the stock exchange: larger firms, on the other hand, become relatively safer because of the higher value of the collateral. As a result, if we assume that the other elements of the balance sheet remains the same, the credit-spread between small and medium

enterprises (SMEs) and large corporations will increase.

Banking channel versus capital market channel

For firms in the economy, there are two ways to obtain finance: they can lend from financial intermediaries such as banks, insurers and pension-funds or they can go to the capital markets,

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where they can issue securities like stocks and bonds. The first is called indirect finance, while the latter is considered to be direct finance (Mishkin, Matthews, Giuliodori, 2013, Chapter 2).

The channel through which monetary policy influences the capital market is a so-called “other asset price-channel”: “Tobin’s q theory” (Mishkin, Matthews, Giuliodori, 2013, Chapter 23). Tobin’s q is the ratio of the market value of the firm relative to the replacement cost of their capital goods, like machines and facilities (Mishkin, Matthews, Giuliodori, 2013, Chapter 23). This channel describes the effect of monetary policy on firms issuing new stocks: if the monetary policy is expansionary, people will buy more stocks since they have more money. This will increase the stock price for the firm, and therefore the market value. It becomes relatively cheap to invest in capital through stock issuance: the investment spending will increase, which has in turn a positive effect on the real economy.

To determine the bank dependence of the Euro-zone, I have used data from the ECB and the Federal reserve to plot the following graph:

Figure 1 : non-financial corporate debt financed by banks in percentage of non-financial corporate debt

For the Eurozone, I have data on loans to non-financial corporations and

debt-securities from non-financial corporations. The data on loans is obtained from the series “All loans to non-MFI, EURO only”. The data on debt-securities is obtained by summing up all types of debt-securities issued by non-financial corporations in euro currency. When we calculate the proportion bank loans in percentage of the total non-financial corporations debt, we obtain the graph above. The US data is obtained using the data package which can be

0,00% 10,00% 20,00% 30,00% 40,00% 50,00% 60,00% 70,00% 80,00% 90,00% 100,00% 2005 2006 2007 2008 2009 2010 2011 2012 2013 Eurozone US 9

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downloaded through the link in the bibliography. I have calculated the proportion of debt consisting of credit market securities: all the other liabilities listed in the data package are financed by banks. The last step is to calculate the proportion financed by banks: we can do this by applying the following formula:

% 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑏𝑏𝑏𝑏 𝑏𝑏𝑓𝑓𝑓𝑓𝑏𝑏𝑏𝑏 = 100% − % 𝑓𝑓𝑐𝑐𝑓𝑓𝑓𝑓𝑓𝑓𝑐𝑐 𝑚𝑚𝑓𝑓𝑐𝑐𝑏𝑏𝑓𝑓𝑐𝑐 𝑏𝑏𝑓𝑓𝑓𝑓𝑠𝑠𝑐𝑐𝑓𝑓𝑐𝑐𝑓𝑓𝑓𝑓𝑏𝑏.

As we can see in figure 1, banks play a significant role in financing non-financial corporations. Approximately 80 % of the non-financial corporate debt is financed by banks in the Eurozone versus 40 % in the US. This means that firms in the Eurozone are more

dependent on banks than firms in the US when obtaining funds for investment. Therefore, it is useful to look at the banking sector and the interest rate pass through: more on that in chapter 2.

Interest rate pass through: Why is it important to know whether the pass through is complete?

The monetary transmission mechanism is crucial when assessing the effectiveness of

monetary policy: its channels describe the way in which monetary policy has an effect on the real economy. As stated by the ECB (2009), it is important to know whether the interest pass through is complete, especially for the Euro-area. This is the case for the Eurozone, because banks play a crucial role in financing the non-financial corporations.

Mishkin, Matthews and Giuliodori (2013, Chapter 23) states that the speed and completeness of the pass through of policy rates determines the impact on the real economy, especially for countries with a “predominantly bank-based financial system”. Since the central bank has goals like price-stability, economic growth and interest rate stability, it is important to know the effect of monetary policy on retail interest rates: particularly in bank-based economies, because most of the saving and investment decisions are depending on these retail interest rates (Mishkin, Matthews, Giuliodori, 2013, chapter 23). If the interest pass through is sluggish and incomplete, monetary policy is almost ineffective in a bank based economy.

The Taylor Rule

Mishkin (2011) discussed in his working paper the common view about monetary policy before the crisis. One of the key principles in this paper is the Taylor principle, which follows from the Taylor-Rule. The Taylor-rule gives a link between the policy rate (the overnight money-market rate) and the inflation and the output-gap (Mishkin, 2011). If the inflation is

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above its desired level, then the inflation-gap becomes positive. This implies that the central bank should increase its policy rate, in order to reduce inflation. The same is true for the output: when output grows above its natural level, the central bank should increase its policy rate, in order to follow the Taylor-Rule. With this higher interest rate, economic activity will be slowed down. The Taylor-Rule is given by :

𝑓𝑓 = 𝑐𝑐∗_{+ 𝜋𝜋 + 0.5(𝜋𝜋 − 𝜋𝜋}∗_{) + 0.5(𝑏𝑏 − 𝑏𝑏}∗_{) (Taylor, 1993),}

where i represents the target interest rate according to the Taylor-Rule, 𝑐𝑐∗ the equilibrium real interest rate, 𝜋𝜋 the actual inflation, 𝜋𝜋∗ the inflation target (for the ECB, 2 % in the medium term), y the actual level of output and 𝑏𝑏∗ the potential output.

One of the implications of the Taylor-Rule is the Taylor principle. According to this principle, the central bank should increase its nominal policy rate at least as much as the inflation rate is above its target (Kwapil & Scharler, 2010). If it does not, then the expectations will change, which will lead to self-fulfilling prophecies: this will result in an undetermined equilibrium, which do not necessarily have to be the desired equilibrium by the central bank.

An important factor which affects the working of the monetary transmission

mechanism is the formation of expectations by the audience (ECB, 2000). The Taylor rule can reduce uncertainty among the public (Gerlach & Schnabel, 2000). If the central bank

messages clearly it will set policy rates according the Taylor rule, the public knows what to expect. As stated by the ECB (2000), the working of the monetary transmission mechanism is dependent on expectations firms and households make. Therefore, it is important for the central bank to have a clear vision on expectations formed by the public.

Gerlach and Schnabel (2000) showed that the EMU interest rates followed the Taylor Rule during the period before the creation of the EMU (between 1990 and 1997), with exception of “the period of exchange market turbulence in 1992-1993”. They conclude that if the ECB sets the interest rates according to the Taylor-Rule with coefficients of inflation gap and output gap equal to 1.5 and 0.5 respectively , the monetary policy will not differ

substantially from the interest setting behavior before the formation of the EMU (Gerlach & Schnabel, 2000). It should be noted that Gerlach and Schnabel (2000) used weights to aggregate data from the separate euro-countries: these weights can change over time, since it

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is based on “GDPs for 1990 expressed in US Dollars”. Therefore, it is questionable if this hypothesis hold in the future.

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Chapter 2: Factors explaining the pass through

Banking competition

Given the importance of the banking sector in the Euro-area, the degree of banking competition is important for the effect of monetary policy on the real economy (Van Leuvensteijn et al., 2013). Therefore, it is important to know if the banking competition in the separate Euro-countries is more or less the same: since the ECB conducts one monetary policy for all countries, it is favorable to have one homogenous, integrated and competitive banking market. If the banking markets differ substantially, monetary policy has different effects on retail interest rates in different countries: in countries with a competitive banking sector, the pass through is stronger and faster than in countries with a less competitive banking sector (Van Leuvensteijn, et al., 2013). Therefore, it is useful to take a closer look at this aspect.

The expectation is that banks in a competitive market will change their interest rates more closely in line with the policy rate (Van Leuvensteijn et al., 2013,). Given that the banks competitors will move its interest rates with the money market rate, the bank will lose market share if they do not follow the other banks in the market. For banks in a market with imperfect competition , it is the other way around: given the fact that customers do not have much of a choice between banks, the bank will act less adequate with respect to changes in the money market rate; it will take in account its own profits without fearing a loss in market share.

Brämer et al. (2013) examined the banking competition in the EMU-countries using a modified Lerner index. The Lerner index measures the difference between the prices in a monopoly and the prices in a competitive market (Martin, 2010, chapter 2). The theory predicts that the “price is equal to marginal cost in the long-run equilibrium of a perfectly competitive market”. If a firm can charge prices above marginal cost, then this firm has market power. One of the findings is that banks have more market power in the loan market than in the deposits market (Brämer et al., 2013).

They also looked at the Herfindahl Hirschmann Index (HHI), which is calculated by taking the sum of the squared market shares of all firms in the market (Martin, 2010, chapter 3). This index gives us the degree of market concentration of the market. To interpret this measure, it is useful to look at the inverse of the HHI: this tells us how many equally sized firms will give the same concentration as found in the market. For example, if the HHI of a

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market equals 0.2, the market is as concentrated as five equally sized firms. Brämer et al. (2013) found major differences between countries: Finland and the Netherlands are the countries with the biggest HHI, while the banking markets of Germany and Italy are the least concentrated markets. They conclude that banking competition explains the development of loan rates in separate economies, but the impact differs across countries. Therefore, the monetary transmission in the Eurozone is not homogenous (Brämer et al., 2013).

Furthermore, Van Leuvensteijn et al. (2013) questioned the usage of the HHI in the context of banking competition. They argue that the HHI do not take the size of the

country or the size of the economy into account. The HHI is a measure of concentration: smaller countries with smaller economies will end up with a higher HHI (Van Leuvensteijn et al., 2013). This could be a possible explanation why the larger EMU countries have a lower market concentration. However, this does not necessarily mean that the banking market is less competitive. It could also be the case that we have a less competitive bank, which is acquired by a major competitive bank. This enhances the competitiveness of the banking sector, but it will increase the concentration of banks (Van Leuvensteijn et al., 2013). If we would only look at the HHI, we would conclude that the market will become less competitive. However, this is not necessarily the case.

The Boone-indicator deals with this problems: it assumes that efficient companies will acquire a bigger market share than the less efficient companies (Boone, 2001). The findings of van Leuvensteijn et al. (2013) suggest that competitiveness , measured by the Boone-indicator, is a significant factor explaining the completeness of the interest-rate pass through in the segments of consumer loans, mortgages and short-term loans to enterprises: it is not significant in the segment of long-term loans to enterprises. In a competitive market, interest rates turn out to be lower than in a less competitive market (Van Leuvensteijn et al., 2013). This is the case, because in a competitive environment, banks have more incentives to lower the loan rates: they hope to gain market share at expense of their competitors. Another result found by van Leuvensteijn et al. (2013) is that bank loan rates follow the money market more closely in a competitive market. Again, if a bank does not follow its competitors during times of decreasing money market rates, it will lose market share; the bank in question will be too expensive in comparison with its competitors. They suggest that improving the

competitiveness of the bank-loan market will improve the transmission of monetary policy (Van Leuvensteijn et al., 2013). This result is slightly contradictive, because Brämer et al. (2013) found that competition has different effects in the Euro-economies. When the effect of

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competition is not the same across all countries, increasing the competitiveness of the banking sector will not improve the transmission of monetary policy in all countries. Improving

competition in the bank markets will lower the interest rates on average, but will not necessarily improve the transmission of the uniform monetary policy in the Euro-area. To solve this problem, it is necessary to equalize the degree of competition in the Euro banking markets (Brämer et al., 2013)

The formation of the EMU and its implications for monetary policy

With the creation of the EMU, the national central banks gave up their mandate to conduct monetary policy. In exchange, they were given a chair in the board of the ECB. Nowadays the ECB conducts one single monetary policy for the Eurozone as a whole. The question is whether this single policy gives different effects in the interest rate development in the individual countries. The prediction established in the paper by Gerlach and Schabel (2000), was that if the ECB conducts monetary policy following the Taylor-Rule, no great deviations will occur in the EMU countries. This analysis has its limits: for example, they have not taken into account the potential role of banking competition in this process. In the previous part, we have seen that banking competition explains the strength of the monetary transmission

mechanism. If the degree of banking competition differs substantially, the effect of monetary policy on interest rates in separate countries are different: in countries with a competitive banking market, the pass through will be more complete than in countries with a less competitive banking. Therefore, the pass-through of interest rates will be asymmetric.

The study of Huchet (2003) investigates how the output of Euro-countries change in reaction to a change of the interest rate. After the simulation, the author concludes that if the ECB conducts one common policy for all EU-countries, it will create asymmetric effects: from the simulation, it becomes clear that the output of France, Germany, Spain and Austria are more sensitive for rising interest rates, whereas the output of Belgium and Italy reacts stronger to expansionary monetary policy (Huchet, 2003). This shows the consequences of conducting one single monetary policy for countries that have structural differences: it can give different results in output across countries.

The empirical research conducted by Clausen and Hayo (2006) differs from Huchet (2003) in the sense that it focusses only on the most important EMU-countries: France, Germany and Italy. Another important difference is that the study by Huchet (2003) was a

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simulation: the article by Clausen and Hayo (2006) includes estimation of and output spillovers, which is mentioned as the demand side. They emphasize the fact that the output gap in one country may have spillover effects to the other EMU-countries. For example, when Italy is in a recession, this will result in a lower Italian import demand. This import demand is the export demand for another EMU country, the Netherlands for instance. If a major part of the Dutch export goods are distributed to Italy, this can have a significant effect on the Dutch economy. They also looked at the supply side, by estimating the inflation-equation. For both the demand and the supply side, they found a significantly different effects among the investigated countries.

The question is whether the formation of the EMU caused structural breaks in the interest rate pass through. This could be either positive or negative: the pass through can become more complete or less complete and the speed can change over time, as the table in the article by Marotta (2009) shows us. In this light, Marotta (2009) found break dates in the lending rates several months after the introduction of the ECU (around 1999) for Italy, Germany and Austria. For some other countries, the author found break dates in the lending rates in the year 2001. The implication of these findings could be that the banking sector adjusts slowly to the introduction of the Euro (Marotta, 2009). It is also clear that these effects are not the same for all countries.

Another result obtained by Marotta (2009) is that the pass through becomes less complete after the break. A possible explanation for this can be that the monetary policy conducted by the ECB is not in line with the economic conditions for a single country. For example, if Spain is in a recession and Belgium experiences a boom, the ECB can decide to lower the marginal lending rate, since Spain has a bigger economy. If the loan demand in Belgium stays strong, the Belgian commercial banks can decide to keep the lending rate at its original level, despite the lower policy rate of the ECB. In this case, the pass-through of the lower policy rate is not complete.

Another insight regarding asymmetries in the Eurozone which can be obtained from Marotta (2009), is given by the fact that the degree of completeness differs among the Euro-countries. As a consequence, the interest rate channel of the monetary transmission

mechanism in the Eurozone differs in strength. This channel becomes more important for countries which experience a more or less complete pass through than for countries with an incomplete pass-through.

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The impact of banking problems on the MTM in the EU

The financial crisis began as a subprime mortgage crisis. As stated by Mishkin, Matthews & Giuliodori (2013, Chapter 8), financial innovation created new lending possibilities for the less-creditworthy borrowers, who have higher default rates than the average borrower.

Housing loans to this group of borrowers are called subprime-mortgages. Through the process of securitization, in which the mortgages with higher default risk are bundled with low-default risk mortgages, banks and other institutions managed to create mortgage-backed securities, mostly with a AAA credit rating (Mishkin, Matthews & Giuliodori, 2013, Chapter 8).

At the beginning of August 2007, these asset-backed securities began to experience losses, due to the rapid decline of housing prices (Mishkin, 2011). From this period till early 2008, the losses on these securities reached the 500 billion dollar range. To put this into perspective, Lehman Brothers had a balance sheet of 600 billion dollar (Mishkin, 2011). In September 2008, Lehman Brothers went bankrupt, mainly due the huge losses on the subprime mortgage market (Mishkin, 2011). Since banks do not know exactly how much of these mortgages are held by other banks, this creates a lack of confidence between banks: they do not know how big the losses on these mortgages are (Karagiannis, Panagopoulos, Vlamis, 2010). These losses can be significant, such that the bank in question will go bankrupt. The implication of this asymmetric information problem is that the interbank lending decreased significantly.

The global financial market stability report from the IMF (2009, chapter 1e) suggests that banks in the US and in the Eurozone are undercapitalized: in the period between 2007Q4 and 2008Q4 the market capitalization halved, while the write-downs tripled and the capital infusions followed nearly the level of write-downs. For Europe, matters can be worse, since Europe is exposed to emerging countries in central and eastern Europe (IMF,2009, chapter 1e). In the same report by the IMF (2009, chapter 1c), it is argued that emerging European countries have financial interaction with Western Europe: banks in western Europe own the majority of banks in these countries.

Two years later, another IMF report from the same publication series (2011, chapter 1c) states that banks, particularly in the Eurozone, have insufficient capital. Banks in the Eurozone are highly dependent on short-term “wholesale funding”, in comparison with banks

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in the US and the UK. Wholesale funding consists of debt and interbank borrowing: the remaining funding possibility is through deposits. As stated by the IMF (2011, chapter 1c), this is caused by the fact that some major banks in the Eurozone lost access to “term-funding markets”: in order to roll over their debt, they are dependent on the ECB or the repo markets.

Europe is more bank based than the VS. Draghi (2013) mentioned in his speech that “around 80 % of the debt of non-financial corporations consists of bank loans “ (2. Financial fragmentation and SME financing). This is confirmed by the graph showed in chapter 1, under the title “banking channel versus capital market channel”.Wehinger (2012) shows that the bank-loan share in the total debt of non-financial corporations is changing over time: due to new regulations, the non-banking sector is taking over the financing of corporations; especially in Europe where the substitution is less advanced than in the US: this is also confirmed by the graph.

To see whether the degree of undercapitalization of the banking sector had an impact on lending to businesses, I have created the following graphs:

Figure 2: Total assets of the Euro banking sector and the debt issued by banks in this sector to non-financial corporations (source: ECB, see bibliography)

18 0 5000000 10000000 15000000 20000000 25000000 30000000 35000000 40000000 2005J an 2005J un 2005N ov 2006A pr 2006S ep 2007F eb 2007J ul 2007D ec 2008M ay 2008O ct 2009M ar 2009A ug 2010J an 2010J un 2010N ov 2011A pr 2011S ep 2012F eb 2012J ul 2012D ec 2013M ay 2013O ct 2014M ar € (in m ill io ns )

Debt issued to non-financial corporations

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Figure 3: Percentage of loans to non-financial corporations on the balance sheet of banks in the Euro-area (source: ECB, see bibliography)

The data can be obtained by following the link in the bibliography. The proportion is obtained by dividing the loans to non-MFI by the total assets. As we can see in the graphs above, the proportion debt to non-financial corporations between 2007 and 2008 decreased. This can be explained by the fact that the debt to non-financial corporations was stable, while the total assets of banks increased. It means that the loans to non-financial corporations have declined less rapidly than figure 3 suggests.

In chapter 3, I will investigate if the monetary aggregate M3 increased, given the fact that the ECB increased the monetary base. Monetary aggregates are used by the central bank to measure the money supply. This aggregate consists of money and money-equivalents, such as overnight deposits (Mishkin, Matthews, Giuliodori, 2013, chapter 3). The composition of the monetary aggregate used by the central bank in question depends on what is considered by a society as a medium of exchange. Financial innovations, which can create new exchange media accepted by the society, can change the composition of the relevant monetary aggregate.

In the Euro-area, the most broadly defined aggregate is M3. This aggregate includes (besides currency and overnight deposits) deposits redeemable within 3 months, deposits with a maturity of 2 years, repurchase agreements, money market fund shares and debt securities up to 2 years (Mishkin, Matthews, Giuliodori, 2013, chapter 3). By increasing the monetary base, the central bank hopes this will drive up the monetary aggregate M3. The M3 money multiplier measures the impact of monetary policy on the monetary aggregate M3.

12,50% 13,00% 13,50% 14,00% 14,50% 15,00% 15,50% 2005J an 2005M ay 2005S ep 2006J an 2006M ay 2006S ep 2007J an 2007M ay 2007S ep 2008J an 2008M ay 2008S ep 2009J an 2009M ay 2009S ep 2010J an 2010M ay 2010S ep 2011J an 2011M ay 2011S ep 2012J an 2012M ay 2012S ep 2013J an 2013M ay 2013S ep 2014J an 2014M ay 19

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There are two issues mentioned by Draghi (2013) regarding financial intermediation, namely heterogeneous lending rates across euro economies and the difference in lending conditions between SMEs (small and medium enterprises) and large firms. The explanation for the first phenomenon is that each country has its own macroeconomic developments (Draghi, 2013). If a country is in a recession, the possibility of companies going into default increases. When a bank determines the interest rate of a loan, it takes the default risk into account. If the loan has a substantial default risk, the bank will ask for a risk premium, which causes the interest rate to rise (Mishkin, Matthews, Giuliodori, 2013, chapter 6). When the economy experiences a downturn, the default risk will increase, causing the average lending rate in a country to increase.

Besides the difference in default-risk, there are other differences in financial markets across the countries in the Eurozone. As stated by the IMF (2012, chapter 2), the financial markets became more fragmented as a result of the sovereign debt crisis. This was caused by the fact that banks and other financial institutions tried to limit their exposure to the troubled countries, such as Greece and Spain. Because these institutions sold sovereign bonds of these countries, the price decreased and the return on these bonds increased. As stated earlier, the degree of banking competition differs among countries. This can explain the differences in lending rates across countries: in countries with a more competitive banking sector, the lending rates turn out to be lower (Van Leuvensteijn et al, 2013).

The second issue is the big spread between the lending rates for the so-called SMEs (small and medium enterprises) and the large firms. According to Draghi (2013), the spread between these two groups of firms are “still high by historical standards”. Wehinger (2012) states that banks have almost the same due diligence cost for SMEs and large firms, but the financing need of SMEs is much smaller than the financing need of the bigger corporations. To compensate for this effects, banks ask for a bigger compensation. Another explanation could be the fact that SMEs have higher leverage levels than large corporations: the

debt/equity ratio is higher for SMEs (IMF, October 2013). Given the riskiness of the balance sheets of SMEs, banks will increase interest rates for these firms to compensate for the default-risk. In order to diminish this effect, the European Commission and the European Investment Bank are exploring possibilities to advance SME financing, most likely by “joint risk-sharing instruments”(Draghi, 2013). They stimulate the provision of loans to SMEs by giving guarantees to banks and other financial intermediaries.

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Beside the problems with smaller firms, there are also firms which are informally rejected or discouraged by banks because of their credit unworthiness. Popov (2013) stresses the importance of taking these firms into account: these firms are systematically omitted from databases, with the consequence that the effect of the credit supply channel of monetary policy cannot be estimated in a proper way. To address this problem, Popov (2013) uses a survey database by the World Bank, which contains data from 8 countries in Eastern and Central Europe, which are considered to be part of Emerging Europe. The key finding of this paper is that if these firms are taken into account in the analysis of the strength of the credit supply channel of monetary policy transmission, the effect of expansionary monetary policy increases: the channel becomes more important (Popov, 2013). Also, if rejected firms are included in the research, the degree of undercapitalization begins to explain the risk-taking behavior by banks under expansionary monetary policy (Popov, 2013).

Undercapitalization of banks

As stated earlier, banks in the Eurozone are undercapitalized: they have too much debt relative to equity on their balance sheets. In the case of a firm, this situation results in a debt-overhang problem: as described by Berk and Demarzo (2011, Chapter 16), firms facing this situation will choose not to invest in opportunities which will generate a positive net present value. This is the case, because equity holders are not willing to invest in the project: after the debt holders are compensated through interest payments, there is insufficient profit left to compensate equity holders for their investment.

In normal times, when a bank has enough capital, it will write down losses. As argued by Caballero, Hoshi and Kashyap (2008), if a bank barely meets the minimum capital

requirements, it will fear writing down losses on bad loans. This means their capital position can deteriorate below the required minimum, which will induce punishment from regulatory institutions. Instead of doing so, they will roll over bad loans to so-called

“Zombie-corporations” (Caballero, Hoshi and Kashyap, 2008). These are non-performing corporations, which are held alive by banks rolling over their debt (Caballero, Hoshi and Kashyap, 2008). With this action, the bank in question hopes that it will get the loan back in the future. They will gamble on the fact that the non-performing firm shows better results in the future. If it does not, the bank does not loose: they have limited liability. The consequence of this reasoning is that the bank in question do not provide loans to the more healthier firms

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anymore. Another consequence identified by Caballero, Hoshi and Kashyap (2008) is the distortion in competition between firms in the sector. It is argued that by supporting non-performing firms, these firms can lower prices of products with the knowledge that banks will help them out (Caballero, Hoshi and Kashyap ,2008).

In order to solve this problem, banks should attract more capital. As stated by IMF (2012, chapter 2), banks have to be recapitalized. The process has started yet, but the 3 year LTROs caused to slow down this process. The liquidity provided by this operation was mainly used to buy government bonds, which made banks more vulnerable to movements in bond yields (IMF, 2012, chapter 2). Because the yields on periphery bonds increased in the aftermath of the LTROs, banks (mainly in Southern-Europe) incurred losses on these bonds: higher yields imply the price of this bonds to decrease, which will give the banks negative returns.

Besides the problems with capitalization, banks have problems with the asset-side of the balance sheet: the loans to corporations. As stated by the IMF (2013, October), the non-financial corporations also have debt-overhang problems: they choose not to invest, and give up positive net present values, which has weakened their performance even further. This has led to an increase of non-performing loans on balance sheets of banks. In order to identify these problems, the ECB announced the Asset Quality Review and additional stress tests (ECB, April 2014).

With this Asset Quality Review and stress tests, the ECB wants to increase the transparency in the banking sector (ECB, October 2013). It gives information about the exposures of banks and the soundness of the banking sector. The other goal is to solve capitalization problems. By conducting stress tests, banks can evaluate what happens to their capital positions in times of downturn. In case of shortfalls, the ECB communicated the time-span in which these problems must be solved by the banks (ECB, April 2014).

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Chapter 3: Analyzing empirical results

As we saw in chapter 2, there are several potential factors which will influence the pass through of policy rates in the Euro-area. In this chapter, this knowledge will be used to explain whether there are structural breaks in the pass through process during the financial crisis and its aftermath. Furthermore, I will discuss the implications for monetary policy.

Changes in the pass through process during the financial crisis

As the article by the ECB (2009) suggests, the recent financial crisis affected the pass through of money market rates on retail bank lending rates. Aristei and Gallo (2014) conducted

empirical research to investigate the impact of the financial crisis, focusing on the bank lending channel. In contrary to the data I presented above, this study also looked at data from households and non-profit institutions serving to households. In this study, they found

evidence that it is necessary to model the interest rate pass through in two states: in the normal state and in the so-called “financial-turmoil” stage (Aristei and Gallo, 2014). This

specification is needed because of structural breaks in the last months of 2008 and the beginning of 2009. Switching to the “crisis-regime” leads to a reduced impact of money market rates on all types of loans considered by Aristei and Gallo (2014). This can be explained by the fact that money markets do not function properly during financial crises. According to Aristei and Gallo (2014), it could also be the case that banks will take advantage from the lower lending rates and use the situation to increase the profit margin.

Belke, Beckmann and Verheyen (2013) concluded their research with the remark that the impact of the financial crisis on the transmission mechanism is “unclear”: it could depend on the financial system and the type of loans. This suggestion has been made, because the pass-through is more homogenous across countries in the corporate loan market than in the loan-to-households market (Belke, Beckmann & Verheyen, 2013). It also depends on the country: the shift dummy, which measures a change caused by the financial crisis, is

significant in some cases, but this differs among countries and loan types (Belke, Beckmann & Verheyen, 2013). This study shows again that the effect of a financial shock has a different impact on the single Euro-countries.

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Karagiannis Panagopoulos and Vlamis (2010) compared the pass through process in the EU and the US in an empirical study. They describe several lessons for monetary policy in a broader context: central banks should have a pre-designed strategy to implement when the markets experience liquidity problems.

Data on M3 and money growth:

As pointed out in chapter 1, the central bank can influence economic activity through monetary policy. With increasing the monetary base, the central bank hopes to increase the monetary aggregate M3. We can analyze this effect through the theory of the money

multiplier. This multiplier gives us a relationship between a movement in the monetary base and the effect on the money supply (Mishkin, Matthews, Giuliodori, 2013, chapter 14).

The money multiplier is given by : 𝑚𝑚 = 1+𝑐𝑐

𝑟𝑟+𝑒𝑒+𝑐𝑐, where c represents the currency ratio in

percentage of deposits (C/D), r the required reserves ratio and e the excess reserves ratio (Mishkin, Matthews, Giuliodori, 2013, chapter 14). The relationship between the monetary base (MB) and the monetary aggregate M3 is given by the following equation: 𝑀𝑀3 = 𝑚𝑚 ∙ 𝑀𝑀𝑀𝑀. Using the data on MB and M3 from the ECB, the M3 money multiplier can be plotted over time by dividing M3 by the monetary base.

Figure 4: Money Multiplier M3 (Source: ECB)

In figure 4, we can see a decline of the money multiplier at the point where Lehman Brothers went bankrupt (around September 2008). At the end of 2011, there is an even sharper decline at the height of the sovereign debt crisis. This means that with increasing the

24 0 2 4 6 8 10 12 01 -01 -20 05 01 -05 -20 05 01 -09 -20 05 01 -01 -20 06 01 -05 -20 06 01 -09 -20 06 01 -01 -20 07 01 -05 -20 07 01 -09 -20 07 01 -01 -20 08 01 -05 -20 08 01 -09 -20 08 01 -01 -20 09 01 -05 -20 09 01 -09 -20 09 01 -01 -20 10 01 -05 -20 10 01 -09 -20 10 01 -01 -20 11 01 -05 -20 11 01 -09 -20 11 01 -01 -20 12 01 -05 -20 12 01 -09 -20 12 01 -01 -20 13 01 -05 -20 13 01 -09 -20 13 01 -01 -20 14

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Monetary Base (MB), the central bank have a smaller influence on the monetary aggregates. From this, we can conclude that the monetary transmission have become less effective. This suggests that the monetary transmission mechanism is disrupted: in the period before

September 2008, an increase of the monetary base by 1 % had moved the money supply as defined by M3 upwards by 10% . In September 2008 this became 8 %, and it decreased even further towards 6 % in 2012/2013, in the aftermath of the sovereign debt crisis.

What is the influence of the ECB on the credit spread in the member-countries of the Eurozone?

To examine whether the central bank can influence lending conditions for non-financial corporations, it is useful to determine if the refinancing rate and the credit spread between corporate debt and sovereign debt are correlated. The credit spread measures the difference in risk between corporate debt and government bonds (Mishkin, Matthews, Giuliodori, 2013, chapter 6). If this spread and the refinancing rate are correlated , the ECB can influence the lending conditions: if the correlation is positive, this means that the ECB can reduce the spread by lowering the refinancing rate through open market operations.

I have used data from the ECB on the 10 year government bonds for two North-European countries (Germany and the Netherlands) and two Southern-North-European countries (Spain and Italy). In order to calculate the spread, I have obtained data on corporate debt with the same maturity. The data on the refinancing rate can also be found on the website of the ECB: the sources can be found in the bibliography. I took data from October 2005 to

September 2009 as the period before the sovereign debt crisis (SDC in the figure), while the period after the sovereign debt crisis consists of data from October 2009 to September 2013: this gives 47 data points for both periods for each country. The correlations can be found in figure 5 and 6.

As we see in these figures, the correlations between the refinancing rate and corporate debt rates were before the sovereign debt crisis close to one. This means that in this period, the ECB had nearly a one to one influence on the lending rates: decreasing the refinancing rate by 1 % implied an decrease of lending rates by nearly 1 %. After the crisis, the

correlations have deteriorated: the greatest impact is seen in Southern-European countries. According to these numbers, the ECB has lost its influence on the lending rates.

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This change is even greater in the correlations between the refinancing rate and the credit spread: after the sovereign debt crisis, the correlation for Germany reaches zero, while the other correlations became negative. This means that be reducing the refinancing rate, the credit-spread remains mainly unaffected in Germany, while this spread increases in the

remaining countries. From these results, we can conclude that the influence of the ECB on the credit spread deteriorated,

Period Spain Italy Germany The

Netherlands Before SDC (Oct. 2005-Sept. 2009) 0.969 0.977 0.988 0.986 After SDC (Oct. 2009-Sept. 2013) 0.017 -0.125 0.916 0.575

Figure 5 : correlations between refinancing rate and interest rates on loans to non-financial corporations

Period Spain Italy Germany The Netherlands

Before SDC (Oct. 2005-Sept. 2009) 0.952 0.921 0.892 0.918 After SDC (Oct. 2009-Sept. 2013) -0.180 -0.656 0.086 -0.200

Figure 6: correlations between refinancing rate and credit-spread

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Conclusion

The central question of this thesis was : Is monetary policy still effective during the financial crisis in the Euro-area? To answer this question, I have looked at the different channels through which monetary policy influences the real economy. Since firms obtain funds from capital markets and financial intermediaries, it is important to find out which channel is the most important one. From figure 1, it becomes clear that the firms in the Euro-area are mainly bank-financed. Therefore, it was useful to look at factors influencing the pass through from policy rates to retail interest rates offered by commercial banks.

The first factor is banking competition: the pass through is more complete and less sluggish in a competitive market. Another important finding is that the influence of

competition on the pass-through process is not equally large in all Euro-countries. This brings us at the second factor: the formation of the EMU and its consequences for monetary policy. The ECB conducts one monetary policy for all EMU-members. The problem is that the several economies react separate from each other. Another insight is given by Marotta (2009): after the formation of the EMU, structural breaks were detected. The pass through becomes less complete after the break date and the degree of completeness differs among the Euro-countries.

The most important factor during the financial crisis and its aftermath is the

undercapitalization of banks in the Eurozone. European banks are facing the problem of debt-overhang. This hampers the provision of loans to corporations in the Eurozone. Given the fact that 80% of the corporate debt in the Eurozone is financed by banks, this will decrease the funds available for firms to invest.

These factors threaten the effectiveness of monetary policy. Therefore, it is important to equalize the competition levels among all Euro-countries. This will increase the

homogeneity of the monetary transmission mechanism. In order to deal with the

debt-overhang problem, banks should attract more capital. If they are adequately capitalized, they will write down losses on bad loans and provide loans to healthy firms. Given the importance of banks in the provision of funds to non-financial corporations, this will drive economic growth and the price level.

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Data: Figure 1:

US: FED: Securities and loans:

http://www.federalreserve.gov/datadownload/Download.aspx?rel=Z1&series=b0d77acdca2d4bd321 629b84a25da84f&filetype=csv&label=include&layout=seriescolumn&from=03/01/2005&to=09/30/2 014 EU: ECB : Loans: http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=117.BSI.M.U2.N.A.A20.A.1.U2.2200.Z01.E Securities: http://sdw.ecb.europa.eu/browseSelection.do?DATASET=0&sfl2=4&REF_AREA=308&sfl3=4&SEC_ISS UING_SECTOR=1100&sfl4=4&SEC_ITEM=&node=17102 Figure 2 and 3:

ECB: Total assets EU banks and loans to non-MFI:

http://sdw.ecb.europa.eu/browseSelection.do?BS_SUFFIX=E&DATASET=0&node=bbn3155&sfl5=3&s fl4=4&sfl3=4&SERIES_KEY=117.BSI.M.U2.N.A.A20.A.1.U2.2240.Z01.E&SERIES_KEY=117.BSI.M.U2.N.A .T00.A.1.Z5.0000.Z01.E Figure 4: ECB Monetary Base: http://sdw.ecb.europa.eu/browseSelection.do?DATASET=0&DATASET=1&DATASET=2&sfl1=3&FREQ =M&node=SEARCHRESULTS&q=base+money&SERIES_KEY=123.ILM.M.U2.C.LT01.Z5.EUR M3: http://sdw.ecb.europa.eu/browseSelection.do?DATASET=0&sfl3=4&BS_ITEM=M30&sfl4=4&DATA_T YPE=1&sfl5=4&node=bbn3478 30

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Figure 5 and 6: ECB

Data on government bonds:

https://www.ecb.europa.eu/stats/shared/download/stats/download/irs/irs/irs.zip Data on corporate debt:

Italy: http://sdw.ecb.europa.eu/browseSelection.do?BS_COUNT_SECTOR=2240&MATURITY_ORIG=O&DAT ASET=0&REF_AREA=190&node=9484266&sfl5=3&sfl2=4&sfl3=4&SERIES_KEY=124.MIR.M.IT.B.A2A.O .R.A.2240.EUR.N Spain: http://sdw.ecb.europa.eu/browseSelection.do?BS_COUNT_SECTOR=2240&MATURITY_ORIG=O&DAT ASET=0&REF_AREA=143&node=9484266&sfl5=3&sfl2=4&sfl3=4&SERIES_KEY=124.MIR.M.ES.B.A2A. O.R.A.2240.EUR.N Germany: http://sdw.ecb.europa.eu/browseSelection.do?DATASET=0&sfl2=4&REF_AREA=262&sfl3=4&MATUR ITY_ORIG=O&sfl5=3&BS_COUNT_SECTOR=2240&node=9484266&SERIES_KEY=124.MIR.M.ES.B.A2A. O.R.A.2240.EUR.N The Netherlands: http://sdw.ecb.europa.eu/browseSelection.do?BS_COUNT_SECTOR=2240&MATURITY_ORIG=O&DAT ASET=0&REF_AREA=244&node=9484266&sfl5=3&sfl2=4&sfl3=4&SERIES_KEY=124.MIR.M.NL.B.A2A. O.R.A.2240.EUR.N

Refinancing rates: http://www.ecb.europa.eu/stats/monetary/rates/html/index.en.html

The impact of the financial crisis on the monetary transmission in the Eurozone