Parsing Financial Frictions Underlying Bank Lending Fragmentation during the Euro Area Crisis

The euro area experience during the financial crisis highlighted the importance of financial and sovereign risk factors in macroeconomic propagation, as well as the constraints that bank lending fragmentation would pose for monetary policy conduct in a currency union. Focusing specifically on the credit intermediation process, we claim that sources of impairments in the monetary policy transmission mechanism can arise from five distinct segments, related both to the demand and the supply of credit, namely: (i) deposit spread, (ii) market-funding cost spread, (iii) bank capital charges, (iv) compensation for expected losses and (v) competitive wedge. These intermediation wedges constitute specific types of financial frictions which may independently be the epicenter of financial disturbances. Against this background we design a DSGE model spanning the relevant "financial wedges" at play during the crisis, together with its cross-country heterogeneity within the euro area, focusing on Germany, France, Italy, Spain, and rest-of-euro area. Our main results are the following. First, we show that the cross-country heterogeneity of micro-structure of financial frictions are relevant to explain the divergence in lending rates. Second, sovereign risk, bank risk and corporate risk have been the most relevant channels to explain the financial heterogeneity observed during the banking crisis (bank capital shock). Third, the corporate risk channel has been the main source of impairment of the monetary policy transmission across euro area countries. Fourth, a 10 pp increase in the annual debt-to-GDP ratio triggers a surge in sovereign yields by than 300 bps and 200 bps for Italy and Spain respectively. Fifth, cross-border financial linkages are more important for Italy and Germany and affect for both countries the transmission of bank capital shocks.