New Research: The effect of monetary policy on the supply of credit: a new approach to identifying the firms' balance sheet channel

09/08/2017
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       Abstract


  • The research examines the effect of monetary policy on firms’ supply of credit through the firms' balance sheet channel, and finds evidence of a Bank of Israel impact via this transmission channel.
  • Based on the research’s findings, the sharp interest rate reduction in Israel in 2008–09, by nearly four percentage points, led to a marked increase in total credit to firms that were facing financial constraints or distress during that period.
  • According to the research, the effect of the interest rate reduction on the supply of credit derives from its contribution to increasing the firms’ market value, which acts to ease terms of credit for them. The research finds that an interest rate reduction of 25 basis points leads to an average increase of 1.25 percent in the firms’ market value, and for financially constrained firms, to an increase of about 0.6–1.2 percentage points in total credit.

 

Research conducted by Gilad Cohen Kovacs from the Bank of Israel Research Department examined the effect of monetary policy on firms’ credit supply via the firms’ balance sheet channel.

 

The firms’ balance sheet channel is one of the mechanisms through which monetary policy impacts on firms’ supply of credit, and through that on economic activity. According to this approach, an interest rate reduction acts to increase the firms’ market value, and therefore to reduce the risk for banks and other financial institutions in providing credit to those firms, and thus to expand the supply of credit to those companies.

 

The research sought to answer the questions of whether the Bank of Israel has an impact via this mechanism, and the magnitude of such an impact. The research utilizes a new methodology for identifying the effect of the firms’ balance sheet channel and uses a sample of approximately 200 public companies traded on the Tel Aviv Stock Exchange in 2007–10.

 

The research finds that a 25 basis-point reduction leads to an average increase of 1.25 percent in the market value of the firms in the sample. In addition, the research finds differences in the market value response of firms to an interest rate reduction deriving from, among other things, differences in their financial structure (Figures 1 and 2).

 

According to the research’s findings, the increase in market value deriving from a 25 basis-point reduction leads to an average increase of 0.6–1.2 percentage points in the quantity of credit for firms facing financial constraints or distress, with the main impact being on long term credit.

 

Overall the findings support the existence of a balance sheet channel in Israel, and based on them it may be assessed that the sharp interest rate reduction in Israel in 2008–09, of approximately 4 percentage points, led to a marked increase in total credit to financially constrained firms.

 

 

Figure 1

The effect of interest rate surprises on market value


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Note: The figure depicts the distribution of the interest rate’s effect on the market value of the firms in the sample. The magnitude of the average response of the market value to an interest rate surprise is -0.05 and the economic significance is that an interest rate reduction of 1 percentage point causes an average increase of 5 percent in the weighted market value of the firms in the sample.

 

 

Figure 2

The estimated effect of changes in the interest rate on market value during the sample period

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Note: The figure depicts the effect of changes in the interest rate during the sample period on the market value of the company with the external sensitivity to changes in the interest rate (that is, the company whose strength of response of market value to an interest rate surprise is at the median of the distribution in Figure 1). The figure indicates that the sharp interest rate reduction that occurred at the end of 2008 led to a marked increase in the market value of most firms in the sample.