Bank Asset Quality and Monetary Policy Pass-Through

50 Pages Posted: 5 Nov 2020

See all articles by David Byrne

David Byrne

Central Bank of Ireland

Robert J. Kelly

Central Bank of Ireland

Date Written: July, 2019

Abstract

The funding mix of European firms is weighted heavily towards bank credit, which underscores the importance of efficient pass-through of monetary policy actions to lending rates faced by firms. Euro area pass-through has shifted from being relatively homogenous to being fragmented and incomplete since the financial crisis. Distressed loan books are a crisis hangover with direct implications for profitability, hampering banks ability to supply credit and lower loan pricing in response to reductions in the policy rate. This paper presents a parsimonious model to decompose the cost of lending and highlight the role of asset quality in diminishing pass-through. Using bank-level data over the period 2008-2014, we empirically test the implications of the model. We show that a one percentage point increase in the impairment ratio lowering short run pass-through by 3 percent. We find that banks with severely impaired balance sheets do not adjust their loan pricing in response to changes in the policy rate at all. We derive a measure of the hidden bad loan problem, the NPL gap, which we define as the excess of non-performing loans over impaired loans. We show that it played a significant role in the fragmentation of euro area pass-through post-crisis.

Keywords: impaired loans, interest rates, monetary policy pass-through, non-performing loans

JEL Classification: D43, E51, E52, E58, G21

Suggested Citation

Byrne, David and Kelly, Robert J., Bank Asset Quality and Monetary Policy Pass-Through (July, 2019). ESRB: Working Paper Series No. 2019/98, Available at SSRN: https://ssrn.com/abstract=3723460 or http://dx.doi.org/10.2139/ssrn.3723460

David Byrne (Contact Author)

Central Bank of Ireland ( email )

P.O. Box 559
Dame Street
Dublin, 2
Ireland

Robert J. Kelly

Central Bank of Ireland ( email )

P.O. Box 559
Dame Street
Dublin, 2
Ireland

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