The Role of Banking in the Transmission of Monetary Policy

This dissertation examines how regulatory requirements cause banks to reduce pass-through of expansionary monetary policy into the interest rates on bank loans.

The first chapter investigates the market structure of the banking sector in the United States. Since 2001, the largest 500 commercial banks (out of over 7,400) have increased their market shares in the markets for bank assets and bank loans from roughly 50% to well over 90%. Using the Panzar and Rosse (1987) H-statistic, the U.S. banking sector is found to be monopolistically competitive. As such, banks appear to have market power in setting interest rates.

Chapter 2, adapted from joint work with Thomas Cosimano and Dalia Hakura, examines whether bank capital plays a role in decision-making by bank holding companies (BHCs). BHCs optimally choose the amount of capital relative to the regulatory requirement. The finding that higher target capital-to-asset ratios cause BHCs to raise loan rates rejects the Modigliani-Miller Theorem that debt versus equity financing should not be a factor in corporate decision-making. Furthermore, higher loan rates result in lower amounts of lending. As a result, raising the capital requirements on BHCs is likely to lead to higher loan rates, and a reduction in lending.

The final chapter examines why bank loan rates tend to adjust well when the monetary policy rate rises, but not when the policy rate falls. A dynamic banking model shows that this asymmetry in interest rate pass-through can be explained by the presence of regulatory requirements imposed on banks. If the regulatory constraint is binding, banks will raise loan rates relative to the monetary policy rate. When the central bank lowers its policy rate, the critical value at which the constraint becomes binding is lowered. This makes it more likely that banks become constrained, and hence reduce pass-through. Empirical evidence corroborates the model predictions that (i) more banks are capital constrained during falling than rising rate periods; (ii) constrained banks adjust loan rates less relative to the federal funds rate, and (iii) the loan rates of constrained banks are more sensitive to demand side fluctuations, compared to unconstrained banks.