Bank Lending Shocks and the Euro Area Business Cycle

I estimate the impact of different types of bank lending shocks on the euro area economy. I first show that the dynamic effects depend on the type of shock. Whereas surges in lending caused by shocks at the supply side of the banking market have a significant positive impact on economic activity and inflation, exactly the opposite is the case for exogenous lending demand shocks. Second, the macroeconomic relevance of bank lending shocks is considerable. Overall, they account for more than half of output variation since the launch of the euro and up to 75 percent of long-run consumer prices variability. The majority of the fluctuations are caused by innovations to lending supply which are orthogonal to monetary policy. A more detailed inspection suggests that these innovations are mainly the result of shocks in the risk-taking appetite of banks triggered by shifts in long-term interest rates or the term spread. Specifically, when long-term government bond yields decline, banks reduce the volume of government loans and securities on their balance sheets whilst increasing the supply of loans to the private sector, which in turn boosts economic activity, inflation and short-run interest rates. Hence, in contrast to conventional wisdom, a falling term spread could predict rising economic activity, which has been the case for some periods within the sample.