The Global Financial Crisis and the Bank Lending Channel

Bank lending is an important but oft-neglected channel through which monetary policy affects the overall economy. A large number of firms, particularly small and medium-sized enterprises (SMEs), depend on commercial banks for funding. The basic idea behind the bank lending channel is as follows: an expansionary monetary policy raises the excess reserves of banks, leading to lower bank lending rates, hence increasing bank lending and economic activity. The bank lending channel works quite effectively during normal circumstances. However, during a situation of bank distress, infusions of liquidity into the banking system may not readily translate into a rise in bank lending as banks become highly risk averse – especially in the face of growing non-performing loans (NPLs) and eroding capital bases (the “capital crunch”) – and choose instead to hoard funds. This in turn implies no change in bank lending rates or the quantity of bank lending.