Corporate Finance and the Monetary Transmission Mechanism

Corporate Finance and the Monetary Transmission Mechanism

Corporate Finance and the Monetary Transmission Mechanism

The reason equity capital has a higher cost than other sources of funding in our model is due to asymmetric information and information dilution costs as in Myers and Majluf (1984). That is, when a bank decides to raise additional equity through a seasoned offer, the market tends to undervalue the issue for the better banks. But because it is the better banks that drive the decision whether to raise equity, the overall effect on all banks’ equity issues (whether good or bad) is to reduce the amount of equity raised relative to the full information optimum. Thus, because of information asymmetries about the true value of bank assets, there is an endogenous cost of equity and, by extension, an endogenous cost of bank lending.
Hence, banks’ equity base (which includes retained earnings) is a key variable in determining the total amount of bank credit. An important consequence of this endogenous cost of equity is that multiple equilibria may exist. In one equilibrium, the endogenous cost of capital (generated by self-fulfilling market beliefs) is high, whereas in the other it is low. The former has all the main features of a ‘‘credit crunch’’1 (i) bank lending is limited by a lower endogenous stock of bank capital; (ii) there is a correspondingly lower volume of bank credit; and, (iii) equilibrium bank spreads are high.2 By contrast, the other equilibrium has a high stock of bank capital, a high volume of credit, and lower equilibrium bank spreads. Another way of thinking about this multiplicity of equilibria is in terms of hysteresis in market beliefs about underlying bank values. Starting from a low level of equilibrium bank capital, a single bank’s decision to issue equity is likely to be interpreted by the market as a bad signal about the issuing bank’s value (resulting in a reduction in the market price of bank equity), thus inhibiting new equity issues. Vice versa, in a situation where most banks are expanding their capital base, a failure to expand will be interpreted as a negative signal. This is the source of multiplicity of equilibria in our model. This multiplicity of equilibria can give rise to potentially large monetary policy transmission effects if a change in monetary stance induces a switch from one equilibrium to another. One possible scenario, for example, is for a tightening in monetary policy to push the economy from an equilibrium with a high equity-capital base and high levels of bank lending into a credit-crunch equilibrium, with a low equity-capital base and low levels of bank lending. How can this happen? One effect of monetary tightening in our model is to reduce equilibrium bank spreads. Once those spreads hit a critically low level, it is no longer worth for banks to maintain a high equity-capital base. In other words, the high equity capital and high lending equilibrium are no longer sustainable, and only the credit-crunch equilibrium can arise for sufficiently low bank spreads. If there is hysteresis, as described earlier, then once the economy has settled in a credit-crunch equilibrium, a major change in interest rates may be required to pull it out of this low-lending equilibrium. That is, the economy may be stuck in the inefficient equilibrium as long as market beliefs are unchanged. An important effect of monetary policy that our analysis highlights is related to the financial composition of the corporate sector between securities issues and bank credit. Recent empirical work suggests that one effect of monetary policy is to change firms’ financing decisions, with corporations substituting bank lending for commercial paper issues. A common explanation for these changes is that when bank cash reserves are tight, firms turn to the securities market to raise funds [Gertler and Gilchrist (1994), Kashyap and Stein (1994)]. Our article, however, identifies a different and more-complex transmission mechanism, which operates through bank equity-capital constraints as opposed to bank reserves.

From “Corporate Finance and the Monetary Transmission Mechanism” Patrick Bolton and Xavier Freixas

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