In the wake of the Great Recession there is a general consensus that monetary easing is key to stimulating investment and to strengthening economic recovery. However, there is a widespread concern that monetary stimulus is not reaching all markets evenly. For example, the International Monetary Fund (IMF, 2012) argues that monetary easing is allowing large corporations to access capital at record low rates, while small firms are struggling to obtain bank loans. Along the same lines, the president of the Federal Reserve Bank of New York suggests that the recent purchases of mortgage backed securities by the Federal Reserve were not effective in lowering primary mortgage rates, in part, because banks increased their margins.
Motivated by such concerns, in this paper I tackle the idea that bank competition affects the transmission of monetary policy across markets. In particular, I analyze the speed and completeness of the pass-through of the monetary policy rate to bank lending rates, and provide evidence on the importance of bank competition to explain heterogeneity in the way banks react to monetary policy impulses, using a unique transaction-level data set that includes all corporate loans of every commercial bank in Mexico from 2005 to 2010. For this purpose, I develop a simple model of the banking firm and test its implications using dynamic panel data methods.
Understanding frictions in the transmission of monetary policy associated with bank competition is particularly relevant for emerging markets today. In a number of these economies, the adoption of stability measures in the last two decades (e.g., fiscal discipline, floating exchange rate regimes, financial sector reforms) has led to an increasing importance of bank interest rates as conveyors of monetary policy shocks (Gaytán and González-García, 2006; Sidaoui and Ramos-Francia, 2007; Berstein and Fuentes, 2004). Moreover, the level of bank concentration in these countries is high.
A simple model of the banking industry
To guide the empirical strategy of this analysis, I develop a simple model of the banking firm that allows for the presence of variable markups. Such markups are a common outcome of a wide range of theoretical models that incorporate imperfect competition in a dynamic setting (e.g., Rotenberg and Saloner, 1984; Bils, 1989; Rotemberg and Woodford, 1990; Dornbusch, 1987; Melitz and Ottaviano, 2008; Atkeson and Burstein, 2008). The model I propose is a dynamic extension of the classical Monti-Klein model of banking. It proposes that banks act as oligopolists and set lending rates based on a markup over the monetary policy rate. Under perfect competition, the model predicts that this markup is constant. However, it suggests countercyclical markups if banks exercise some degree of market power. This in turn implies that the pass-through of policy rate impulses to lending rates will be incomplete in markets with imperfect competition. The idea behind this result is that the availability of alternative sources of financing for borrowers varies along the business cycle and thus banks face a pro-cyclical elasticity of demand. During economic booms, the effect of monetary tightening on lending rates will be buffered by lower markups, while during a recession the effect of monetary easing will be attenuated by higher margins. Under perfect competition, however, markups are constant because the elasticity of demand in this case is always infinite.
What do I find?
Using a unique loan-level data set containing more than 1.4 million observations, I find that banks adjust corporate lending rates sluggishly to monetary policy shocks in Mexico. I also find that this adjustment is less than proportional to the change in the policy rate (i.e., incomplete pass-through), and that it is more incomplete when the monetary policy rate is reduced compared with when it increases (i.e., asymmetric pass-through).
In addition, I find that differences in the degree of bank competition are important to explain heterogeneity in the transmission of policy rates across markets. A market with a number of banks in the 10th percentile has a pass-through of only 0.6, while a market in the 90th percentile has a pass-through of 0.9. Incomplete and heterogeneous long-term pass-through are opposite to many earlier studies. However, they support the idea that monetary policy shocks do not reach all markets evenly.
These findings provide evidence on the importance of microeconomic factors in understanding a crucial macroeconomic issue: they suggest that banks exercise different degrees of market power across regions and that this generates frictions in the transmission of monetary policy. These frictions undermine the effectiveness of central banks to affect retail interest rates through the money market, particularly in the case of monetary policy easing. Interestingly, my results also imply that the conduction of monetary policy has important distributional consequences for the cost of corporate financing across markets.
Monetary stimulus is shown to be less effective in reducing the cost of bank loans for small firms and firms located in markets where bank competition is low. In the absence of alternative sources of finance, this may affect the distribution of investment and economic activity. The next logical question is: How important are these frictions for economic activity? This question is harder to answer with my data set. While my results leave open the possibility that bank competition generates substantial heterogeneity in the cost of funds across regions, an attempt to precisely measure the effect on investment is hampered by the availability of information about the costs of alternative sources of corporate finance. To make progress on this front, I need to be able to measure the elasticity of substitution between bank and non-bank financing.
From a methodological point of view, interesting extensions of this analysis may take into account strategic behavior of banks across markets and products, as well as the importance of relationship lending.
References
Atkeson, A., and A. Burstein. 2008. "Pricing-to-Market, Trade Costs, and International Relative
Prices." American Economic Review, American Economic Association 98(5, December): 1998-2031.
Dornbusch, R. 1987. "Exchange Rates and Prices." American Economic Review, American Economic Association 77(1, March): 93-106.
Gaytán, A., and J. González-García. 2006. “Structural changes in the transmission mechanism of monetary policy in Mexico: A non-linear VAR approach.” Documento de Investigación 2006–06, Dirección General de Investigación Económica, Banco de México.
International Monetary Fund. 2012. "World Economic Outlook October 2012, Coping with High Debt and Sluggish Growth." International Monetary Fund.
Melitz, M., and G. Ottaviano. 2008. "Market Size, Trade, and Productivity." Review of Economic Studies, Wiley Blackwell 75(1): 295-316.
Rotemberg, J., and M. Woodford. 1990. "Cyclical Markups: Theories and Evidence." NBER Working Papers 3534, National Bureau of Economic Research, Inc.
Rotemberg, J., and G. Saloner. 1987. “The Relative Rigidity of Monopoly Pricing.” American Economic Review, American Economic Association 77(5, December): 917-26.
Sidaoui, J.J., and M. Ramos-Francia. 2008. "The Monetary Transmission Mechanism in Mexico: Recent Developments." In Transmission Mechanisms for Monetary Policy in Emerging Market Economies, Bank for International Settlements 35: 363-94.
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