Monthly Report: Monetary policy transmission depends on bank capital

In a low-interest-rate environment, accommodative monetary policy can dampen commercial banks’ lending business. This is possible, in particular, if commercial banks hold only a small amount of capital. This is the conclusion drawn by Bundesbank economists in the current issue of the Bundesbank’s Monthly Report. A relationship of this kind would, in and of itself, run counter to commercial banks’ objective of increasing their lending volume.

Margins under pressure

According to the Bundesbank’s economists, the abovementioned effect could unfold via the bank capital channel, which describes the impact of monetary policy via interest rates and the interest rate structure on banks’ profitability and, by extension, their ability to generate equity. Above all, banks use their equity capital to absorb potential losses. Banks therefore need capital if they wish to expand their lending business.

The studies referred to in the Monthly Report article show that a bank’s net interest margin can come under pressure in an environment of low interest rates. The net interest margin is the difference between the interest that commercial banks receive on their assets, eg loans, and the interest they have to pay on debt, eg in the form of deposits held with them. As the net interest margin constitutes a crucial part of profitability, a decline amidst the low-interest-rate setting can, in and of itself, lower a bank’s profitability. Hence, according to the Monthly Report, in a low-interest-rate environment a situation may arise where “expansionary monetary policy measures could, at least in the longer term, weigh on profitability, whereas restrictive measures would support profitability, impacting accordingly on banks' ability to build up capital and thus, in principle, also on lending”.

Adverse effects dependent on capital adequacy

The Bundesbank’s experts believe the described effect is especially true for banks which already have a very small capital base – ie those which hold just enough capital to comply with regulatory requirements. If access to equity capital in the market is constrained as well, this likewise encourages the effect. Good capital adequacy levels are therefore crucial from a monetary policy perspective, the economists write. Although the banking system has improved its capital adequacy considerably over the past few years in the euro area, stocks of non-performing loans are still very large in some countries, however, which could weigh on capital adequacy in future. The worse the capital base of banks is, particularly in this low-interest-rate environment, the stronger any adverse reactions of the banks to monetary policy measures are likely to be, and the “harder it will become for monetary policymakers to achieve their objective of maintaining price stability,” report the experts.

The Bundesbank’s economists also point out that their findings are not consistent with previous analyses of the bank capital channel in the academic literature which had considered this channel to be an amplifier of monetary policy. In those studies, however, there was no assumption of an environment in which interest rates would remain very low for a long period.