Bank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial development

Bank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial developmentBank lending mechanism of monetary policy transmission The role of bank capital, bank competition, and financial development

INTRODUCTION

Research background

Access to bank loans is essential for driving economic growth in underdeveloped economies, as it allows enterprises to undertake investment projects (Vo, 2018) Various factors influence the availability of bank loan supply, but recent studies emphasize the significant role of monetary policy in shaping this supply (Bernanke, 2007; Disyatat, 2011; Kashyap and Stein).

Monetary policy plays a crucial role in economic development, inflation control, and the availability of credit It operates through various pricing and quantitative instruments that influence the real economy to achieve price and financial stability The impact of monetary policy on bank lending activities has significant implications for the overall economy Ongoing debates exist regarding the mechanisms of monetary policy transmission, particularly through the bank lending mechanism (BLM) and its under-explored determinants Understanding these factors is essential for policymakers to design effective monetary policies and for researchers to evaluate the efficacy of monetary actions This thesis focuses on the BLM and its reliance on several potential factors discussed in previous studies.

Monetary policy significantly influences economies through various transmission channels, such as credit, interest rates, asset pricing, and exchange rates (Mishkin, 2007) The effectiveness of these channels varies across different economic structures Notably, the banks’ credit channel has become increasingly important since the 2007 global financial crisis, which adversely affected the stability of the global banking sector This channel illustrates how banks shape the impact of monetary policy on the real economy, primarily through lending to the real sector However, the effectiveness of monetary policy interventions in loan intermediation remains a critical question Research suggests that bank lending is particularly effective in emerging economies, where the bank lending channel serves as a key mechanism for successful monetary policy, given their reliance on bank financing (Montiel et al., 2011).

Mishkin (1996) emphasizes the role of information asymmetry in the credit channel of monetary policy transmission, identifying two key pathways: the balance sheet channel and the bank lending channel (Bernanke and Gertler, 1995) The bank lending channel, based on Bernanke and Blinder's (1988) model, suggests that a tightening monetary policy reduces bank deposits, subsequently lowering the overall loan supply Conversely, Bernanke et al (1996) propose that monetary policy impacts lending agency costs, where monetary contractions can decrease borrowers' net worth, increasing agency costs, especially for firms with lower net worth In Bernanke and Gertler's (1986) model, lenders restrict credit to riskier businesses and favor safer investments as agency costs rise This thesis focuses on the bank lending channel, utilizing disaggregate bank-level data to explore its existence and its dependence on factors such as bank balance sheet items, market structure, and financial development.

1.1.1 The main focus on the bank lending channel of monetary policy transmission

Monetary policy transmission occurs through various interconnected channels, including the interest rate, exchange rate, and credit channels Mishkin (1996) explores the traditional interest rate channel and the bank lending channel, highlighting that contractionary monetary policy raises real interest rates, which increases capital costs and reduces investment spending, ultimately lowering aggregate demand and output However, the assumption of perfect substitutability between bank loans and bonds oversimplifies the monetary transmission mechanism, as small and medium-sized enterprises often rely on bank loans due to limited access to bond markets Research by Stiglitz and Weiss (1992) emphasizes the unique role of banks in screening and monitoring borrowers, leveraging their information-gathering capabilities to mitigate information asymmetry and gain a competitive advantage in debt markets.

The current thesis focuses on the bank lending channel, which highlights how a bank's credit supply is influenced by changes in monetary policy Bernanke and Blinder (1988) provide a theoretical framework using the IS-LM model, establishing three key assumptions for the transmission of monetary policy through this channel: (i) bank loans and bonds are not perfect substitutes, (ii) regulatory authorities can control the loan supply of financial institutions, and (iii) imperfect price adjustments are assumed to prevent the neutral money problem.

BLM arises from the impaired functioning of capital markets and incomplete contracts, challenging the Modigliani and Miller theorem (1959) Asymmetric information and agency problems create imperfections that negatively affect lenders' expected returns and increase borrowers' funding costs Consequently, banks struggle to transition between funding sources, making it difficult for businesses to substitute bank loans with alternative financing options like market debt This underscores the critical role of monetary policy through the bank lending channel, which can significantly alter economic conditions However, the effectiveness of monetary policy on loan supply is influenced by various factors, particularly the characteristics of banks, such as capital levels and market competition, as well as the overall financial development.

1.1.2 The role of bank capital in monetary policy transmission

The varying effects of monetary policy through the bank lending channel (BLM) across countries can be attributed to several factors Research indicates that weaker banks struggle to shield their lending from monetary policy shocks, resulting in a reduction of bank loans When monetary policy tightens, the negative impact on bank lending arises because the decrease in reservable deposits cannot be offset by non-reservable liabilities The bank debt market is not frictionless, leading to a "lemon’s premium" for uninsured non-reservable obligations Bank capital plays a crucial role, influencing external ratings and signaling creditworthiness to investors Consequently, undercapitalized banks face higher costs for non-reservable funding, as they are perceived as riskier, making them more susceptible to asymmetric information issues and hindering their ability to maintain credit relationships.

The sensitivity of bank loan supply to monetary policy shocks is influenced by bank capital, highlighting the distributional effects of monetary policy Sáiz et al (2018) reveal that the impact of different monetary policy regimes affects banks across various capital levels Their findings show that the reduction in bank loan supply due to monetary tightening is consistent across all capital levels, while well-capitalized banks are able to increase their loan supply more significantly during periods of monetary expansion.

1.1.3 The dependence of monetary policy pass-through on market structure

The existing literature on bank lending has largely concentrated on its significance and existence, leaving the response of bank loan supply to monetary policy—considering factors beyond bank capital levels—relatively under-researched.

Recent literature has shifted focus to the factors influencing monetary policy transmission through the bank lending channel, particularly the often-overlooked banking market structure Research indicates that a competitive banking environment may weaken monetary transmission via bank lending, as banks with significant market power can maintain their lending levels despite contractionary monetary policies This is due to their ability to access alternative funding sources, allowing them to expand their balance sheets without reducing loan supply.

1.1.4 The impact of monetary policy transmission depending on financial development

The development of financial markets, encompassing both the banking sector and capital markets, plays a crucial role in the disparities in Bank Lending Margins (BLM) and Monetary Policy Transmission (MPT) across countries Research by Gertler and Rose (1994) indicates that a larger and more liquid banking sector enhances financial intermediation, which reduces financial costs and strengthens banks' balance sheets Furthermore, the expansion of capital markets improves financial liquidity, leading to increased bank lending and greater access to external funding for banks Consequently, the growth of both the banking sector and capital markets can significantly enhance the effectiveness of monetary policy through the bank lending channel.

Financial development, driven by key components like the banking system and stock market, enhances access to external funding (Altunbas et al., 2009; Ferreira, 2010) In well-developed financial systems, monetary policy changes have a diminished impact on bank loan supply due to banks' diverse financial instruments and funding sources Conversely, in less developed economies, the bank lending channel plays a vital role in monetary policy, as underdeveloped financial markets rely heavily on deposits as the main source of bank funding.

Research motivations and research gaps

1.2.1 The “Black box” of monetary policy transmission: The need for further research

The transmission of monetary policy remains unclear, with economists agreeing on its short-term impact on the real economy, yet the exact mechanisms involved are still a "black box" (Bernanke and Gertler, 1995) While there is a consensus on the effects of monetary policy, the specific channels and factors driving these effects are still debated The intricate relationship between monetary policy transmission and its economic influence continues to be a topic of discussion, highlighting the complexity of this "black box."

The impact of monetary transmission on financial intermediaries remains a topic of debate, with authorities historically prioritizing interest rate communication over the bank lending channel Bernanke and Blinder (1988) emphasized that monetary policy significantly affects the credit channel, as changes in central bank policy rates influence credit costs and availability more than mere interest rate adjustments This credit channel is divided into two components: the balance sheet channel and the bank lending channel, as noted by Bernanke and Gertler.

Recent research highlights the crucial role of banks in the transmission of monetary policy, particularly through their lending capabilities This thesis emphasizes that understanding how banks influence monetary policy is essential for assessing its economic impacts The theory of information asymmetry between lenders and borrowers provides a clear rationale for how monetary policy affects the real economy via the supply of bank loans.

The empirical investigation of the Bank Lending Mechanism (BLM) has been conducted across various economies, revealing that while monetary policy is effective in developed countries, its impact in developing nations remains uncertain In developed economies, the interest rate channel is considered the most effective for monetary transmission, whereas the bank lending channel is more significant in developing countries Despite numerous studies yielding inconclusive results regarding the bank lending mechanism, its potential existence is believed to enhance the understanding of BLM and its determinants in emerging markets, offering insights into the complexities of this "black box."

Despite the established body of research on the Bank Lending Mechanism (BLM) of monetary policy, it is essential to re-estimate the BLM in Vietnam due to several factors Firstly, previous studies have relied on aggregated data, which has faced criticism for issues related to the identification of loan demand versus supply and for not accounting for the heterogeneity among banks Secondly, existing research using bank-level data in Vietnam is outdated and fails to incorporate significant dummy variables, such as the financial pressure period in the Vietnamese banking sector and the impact of state ownership Furthermore, there has been insufficient focus on the normalized procedures for bank-specific characteristics and the nested stepwise regression approach.

1.2.2 Aggregated data versus disaggregated data

Recent studies have shifted from traditional time series approaches to analyzing individual bank behavior using panel data models to understand how monetary policy shocks affect bank loan supply Bernanke (1990) was among the first to utilize aggregate bank-level data from the U.S banking industry, covering 1959 to 1978, and found that the federal funds rate serves as a reliable predictor of changes in macroeconomic activity This research suggests that monetary policy influences the banking sector by connecting banks' credit and deposits.

In 1995, researchers sought to clarify how monetary policy influences actual production and expenditure They identified the credit channel as a key pathway for the transmission of monetary policy, which subsequently impacts the real economy.

A key limitation of aggregate-level research is its inability to differentiate between changes in bank lending behavior due to shifts in loan demand versus loan supply, known as the "identification problem" (Bashir et al., 2020) This challenge arises because disaggregated data may obscure whether fluctuations in bank loans are driven by monetary policy adjustments Consequently, recent studies have increasingly utilized bank-level panel data to explore the bank lending channel (BLM) at a more granular level.

Empirical studies on the bank lending channel have primarily examined the relationships between aggregate output, bank debt, and monetary policy variables However, this analysis faces challenges in differentiating between changes in loan demand and shifts in loan supply Consequently, both output and bank loans tend to decline after a monetary tightening, without clarifying whether the reduction in loan volume is due to restricted loan availability or decreased loan demand through the traditional interest rate mechanism (Oliner and Rudebusch, 1995).

Several studies have utilized disaggregate bank-level data to analyze cross-sectional differences among banks, aiming to differentiate between movements in loan supply and demand (Bashir et al., 2020; Dang, 2020; Hussain and Bashir, 2019; Sáiz et al., 2018; Sanfilippo-Azofra et al., 2019; Sanfilippo-Azofra et al., 2018) This approach posits that specific bank characteristics, such as size, liquidity, capitalization, and competition, primarily drive fluctuations in loan supply, while loan demand remains unaffected by these factors Following a monetary tightening, the reduction in overall deposit availability, which influences banks' capacity to issue new loans, varies across institutions (Gambacorta, 2005) This thesis leverages bank-level data to tackle the identification issue by focusing on bank-specific traits like size, liquidity, capital, and credit risk, independent of loan demand It emphasizes the interaction between bank capital and monetary policy changes as a key variable, while other bank-level variables serve as controls, thereby establishing the bank lending mechanism in the context of monetary policy transmission.

Investigating bank-specific characteristics is essential for understanding the monetary policy pass-through through the bank lending mechanism, as aggregate data fails to capture these nuances Utilizing bank-level data allows for the identification of cross-sectional heterogeneity influenced by unique bank features, as highlighted by research from Cetorelli and Goldberg (2008) and Kashyap and Stein (1995, 2000), along with Peek and Rosengren.

Recent studies, including those by Abuka et al (2019), indicate that the bank lending channel (BLC) in emerging countries is weak, primarily due to reliance on aggregate data This raises the question of the existence and effectiveness of the BLC, which remains insufficiently explored Therefore, it is essential to reassess the presence and strength of the bank lending mechanism by utilizing disaggregated data from bank balance sheets.

1.2.3 The role of bank-specific heterogeneity on monetary policy transmission: The case of bank capital

This thesis explores the diverse factors contributing to bank heterogeneity, which leads to varying responses to monetary policy impacts on the bank lending channel One perspective highlights that imperfections in the credit market significantly influence the lending behavior of financial institutions These imperfections affect how banks react to changes in monetary policy, suggesting that the supply of bank loans is linked to their ability to secure external funding Consequently, banks may possess a protective capacity to maintain their lending operations despite adverse shocks from monetary policy transmission Notably, capital has emerged as a critical variable in assessing a bank's financial strength, especially in light of its essential role in sustaining lending during crises and adhering to the new capital requirements established by the Basel Accords.

Bank capital has gained significant attention from researchers following the 2007-2008 financial crisis due to its essential role in establishing capital buffers and ensuring stable financial resources, which are crucial for sustaining and expanding lending activities (Louhichi and Boujelbene, 2017; Dang and Dang, 2021a) Well-capitalized banks possess more equity securities to absorb potential losses and face fewer moral hazard issues, as a greater portion of their capital is at risk (Kishan and Opiela, 2000; Van den Heuvel, 2002a; Bernanke, 2007) These banks are likely to maintain higher capital reserves to mitigate risks associated with monetary policy changes, allowing them favorable access to external financing Consequently, they may adopt a risk-averse stance, leading to a cautious approach in lending practices, which is linked to a decrease in moral hazard.

Recent research highlights the significant role of bank capital in influencing monetary policy transmission through bank lending Specifically, bank capital is crucial for mitigating the effects of monetary tightening or loosening on loan supply However, the existing literature often overlooks how different monetary regimes impact bank loan supply based on varying levels of bank capital It is essential to recognize that the effectiveness of monetary policy pass-through varies during periods of tightening and loosening, a topic that has not been extensively explored in prior studies.

Research objectives

Research objectives stem from the first fundamental impact of monetary policy indicators on bank loan supply, which creates the examination for the presence of BLM

The primary goal of this study is to reexamine the transmission of monetary policy through BLM by utilizing updated features, including the latest data up to 2020, a normalization process, a two-step system GMM approach, and nested stepwise regression techniques.

This research initiative aims to explore the relationship between bank lending and monetary policy changes by examining the determinants of monetary policy pass-through via Bank Lending Mechanism (BLM) The study establishes a baseline model to analyze how bank loan supply responds to monetary policy shocks, integrating critical factors such as bank capital, bank competition, and financial development The focus is on understanding the existence of BLM and the driving roles of these factors in the transmission process.

 The second objective: Investigating the heterogeneous response of bank-level loan supply to monetary policy depending on both monetary regimes and bank capital levels

 The third objective: Examining the distributional effect of bank competition on BLM

 The final objective: Discovering the distributional impact of financial development on BLM.

Research questions

This thesis seeks to confirm the effectiveness of monetary policy transmission through the established bank loan supply channel and to explore the various factors influencing the bank lending channel, addressing the key research questions (RQ) outlined earlier.

 RQ1: Does a bank lending channel of monetary policy transmission exist in a typical emerging market such as Vietnam?

 RQ2: Is the heterogeneous effect of monetary policy on bank loan supply depending on bank capital levels?

 RQ3: Does the bank loan supply respond to changes in monetary policy conditioned by bank competition?

 RQ4: Does the bank loan supply respond to changes in monetary policy depending on financial development?

Understanding the conditions that enhance the efficiency of the bank lending channel is crucial for effective monetary policy implementation By analyzing the various impacts of key factors on bank lending metrics (BLM), policymakers can make informed decisions that align with their objectives, ultimately facilitating better economic outcomes.

Research scope

This thesis aims to investigate the presence of Bank Liquidity Management (BLM) in Vietnamese commercial banks and its relationship with bank capital, competition, and financial development from 2007 to 2020 The focus on commercial banks is intended to minimize bias from the diverse objectives and operations of various financial institutions (Wang and Luo, 2021) To ensure data accuracy, a comparison of annual bank-level data from the Bankscope database with audited financial reports is conducted Additionally, macroeconomic statistics, including GDP growth, are sourced from the World Development Indicators (WDI).

Research methodology

This thesis utilizes the two-step system generalized method of moments (S-GMM) as proposed by Arellano and Bover (1995) and Blundell and Bond (1998) to effectively tackle econometric challenges such as endogeneity, heteroskedasticity, and autocorrelation This approach is particularly beneficial for panel data with a large number of cross-sectional observations (N) relative to a shorter time period (T) Additionally, nested stepwise regression is applied to incorporate control variables into the baseline model sequentially, allowing for a sensitivity analysis of the main results based on the selected controls.

To enhance the understanding of the marginal effects of monetary policy and align with common practices in analyzing bank lending determinants, we preprocess variables related to banks' balance sheet items—such as capitalization, size, liquidity, and credit risk, measured by the loan loss provision ratio—using a normalization procedure prior to incorporating them into the main model.

The study examines the varied effects of monetary policy transmission through bank capital levels by utilizing squared interaction terms between monetary policy tools and bank capital Continuous variables allow for an in-depth analysis of how both restrictive and expansionary monetary regimes influence loan supply across different bank capital levels Additionally, the results are visually represented through plots following marginal analysis, effectively illustrating the model outcomes captured in the squared interaction terms.

Research contributions

This thesis contributes to the literature on Bank Lending Mechanisms (BLM) by examining its reliance on key emerging factors, including bank capital, competition among banks, and the overall development of the financial sector.

Research on the presence of the bank lending channel (BLM) is primarily focused on developed countries, yielding mixed results regarding its effectiveness in monetary policy Early studies predominantly examined banks in the United States, while subsequent research has validated the significance of the bank-lending channel in regions such as Central and Eastern Europe (Matousek and Sarantis, 2009) and India (Bhaduri and Goyal).

Recent studies on the bank lending channel (BLM) have primarily focused on developed countries, with fewer investigations into emerging markets like Vietnam This research revisits the BLM in Vietnam by utilizing updated methodologies, including disaggregated databases for bank balance sheet items, data extending to 2020, and a broader range of control variables Employing the System Generalized Method of Moments (S-GMM) and nested stepwise regression, the findings confirm the existence of monetary policy transmission through the bank lending channel in Vietnam, highlighting its characteristics as a bank-based emerging market with a diverse monetary policy implementation approach.

This article explores the distributional effects of monetary policy on bank loan supply, emphasizing the influence of bank-specific characteristics on the effectiveness of monetary policy transmission It highlights a gap in existing research regarding the heterogeneous effects of monetary policy in emerging markets like Vietnam, particularly concerning different levels of bank capital Previous studies have often overlooked this aspect by focusing on categorical variables, which limits their analysis This thesis introduces a novel approach by utilizing squared interaction terms between bank capital and monetary policy indicators, accompanied by illustrative plots, to enhance the understanding of the asymmetric impacts of both contractionary and expansionary monetary policy across varying bank capital levels.

Research on bank competition in Vietnam primarily examines banks' stability and efficiency, often overlooking the influence of competition on the effectiveness of monetary policy pass-through via Bank Lending Mechanism (BLM) Previous studies indicate that banks with strong competitive capabilities can access a broader range of funding sources beyond just deposits or interbank loans, allowing them to better absorb monetary policy shocks Furthermore, heightened competition may reduce informational asymmetry regarding borrowers' financial profiles, thereby decreasing switching costs for borrowers moving from smaller to larger banks that offer more reliable loan supplies However, there is still limited understanding of how bank competition affects the transmission of monetary policy.

Fourthly, monetary policy may influence banks’ access to loanable funds and, consequently, their capacity to provide granted credit through influencing bank reserves

Banks that rely heavily on deposits for financing are more vulnerable to shifts in monetary policy, as noted by Bernanke and Blinder (1988) Financial development enhances liquidity in the sector, providing banks with greater access to diverse external funding options Consequently, this development can mitigate the effects of monetary policy through the bank lending channel This phenomenon has been observed in Vietnam, highlighting a crucial aspect that previous studies have overlooked.

Structure of thesis

This thesis comprises five chapters that examine how monetary policy is transmitted through the bank lending mechanism, influenced by internal factors such as bank capital levels and competition, as well as an external factor, financial development, in Vietnam Each chapter provides a detailed analysis of these dynamics.

This chapter outlines the research background, motivations, objectives, questions, scope, methodology, contributions, and a structured summary of the dissertation It focuses on the existence of the bank lending channel of monetary policy transmission in emerging countries, examining how bank heterogeneity—specifically bank capital and competition—affects this channel Additionally, the thesis emphasizes the varying impact of monetary policy on bank loan supply based on different capital levels and the distributional effects influenced by bank competition and financial development.

 Chapter 2: Literature review and hypotheses development

This chapter presents compelling evidence of a bank lending mechanism for monetary policy transmission, prompting a re-evaluation of this channel in Vietnam, a small open emerging economy After establishing the presence of this transmission channel, the chapter discusses several factors that influence the effectiveness of monetary policy While traditional views recognize bank capital as a moderating factor, this thesis introduces a novel approach to examine the heterogeneous effects of bank capital on the effectiveness of monetary policy pass-through, advocating for further research to enhance understanding of how varying levels of bank capital impact this process.

Recent studies have highlighted the distributional effects of monetary policy influenced by factors like bank competition and financial development However, there is a notable lack of research focusing on small-open emerging markets, particularly Vietnam This article aims to address these research gaps by formulating hypotheses grounded in the existing literature on the conditionality of monetary policy, bank capital, bank competition, and financial development.

 Chapter 3:Research data and methodology

This chapter presents research data on a comprehensive sample of commercial banks in Vietnam from 2007 to 2020 It details the specifications for each hypothesis, confirming the existence of the bank lending channel (Hypothesis 1) and identifying key drivers of monetary policy transmission through bank lending mechanisms, including bank capital, competition levels, and financial development (Hypotheses 2, 3, and 4).

This chapter presents the econometric regression estimation, including a diagnostic test for the system generalized method of moments to ensure the consistency and suitability of this method for all testing equations Additionally, it introduces a novel approach to marginal effect analysis and plot illustration, with comprehensive calculations and justifications This innovative marginal approach is a key contribution of this thesis.

 Chapter 4: Empirical evidence and discussion

This chapter discusses the key factors influencing monetary policy transmission, particularly in the context of Vietnam It confirms the existence of monetary policy transmission and presents regression results that highlight the effects of bank capital, competition, and financial development on this process.

Chapter 5 summarizes the research findings from Chapter 4, highlighting the contributions of this thesis to the literature on monetary policy transmission through the bank lending channel and its key drivers, including bank capital, competition, and financial development Based on these findings, policy recommendations are offered to enhance the effectiveness of monetary policy propagation by considering the significant determinants involved Additionally, the thesis acknowledges its limitations, which open up potential avenues for future research.

LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT

Bank lending mechanism of monetary policy transmission

2.1.1 Introduction to the bank lending channel of monetary policy

Central banks use monetary policy to manage the real economy, aiming for low inflation, high employment, and long-term growth This policy influences economic activity through various channels, such as interest rates and credit availability Bernanke (1993) highlighted the importance of understanding the relationship between money, credit, and the economy to address structural and forecasting issues Bank credit plays a crucial role in financing small and medium-sized enterprises (SMEs) due to economies of scale and information asymmetry The credit channel is divided into the bank balance sheet channel and the bank lending channel, the latter acting as a "financial accelerator" that shows how monetary policy shocks affect both banks' liabilities and their ability to supply credit The balance-sheet channel focuses on the impact of monetary changes on borrowers, while the bank lending channel examines how monetary policy affects loan supply Bernanke and Gertler (1995) emphasized the significance of financial institutions in monetary transmission, indicating that monetary authorities influence the economy through the banking system by controlling credit volume, which is affected by financial market imperfections and the availability of alternatives to bank loans.

The interest rate channel and the bank lending channel (BLM) represent distinct mechanisms of monetary policy transmission According to Bean et al (2002), changes in monetary policy influence long-term interest rates, which in turn affect relative prices, consumption, and investment Conversely, Bernanke and Blinder (1988) highlight the bank lending channel, where monetary policy tightening raises the opportunity cost of holding deposits, thereby reducing the availability of bank loans When financial institutions face liquidity constraints due to increased interest rates, the economy may slow down as reserves and deposits decline, limiting the supply of loanable funds This situation can lead banks to restrict their loan portfolios if they struggle to issue uninsured liabilities to offset the decrease in loanable funds Ultimately, the bank lending channel underscores the critical role of banks in the financial system and the interconnection between bank deposits and loan supply.

2.1.2 Theoretical perspective on the presence of bank lending mechanism of monetary policy transmission

The transmission mechanism of monetary policy is fundamentally structural, influenced by theoretical frameworks The traditional Keynesian IS-LM model suggests that monetary shocks affect interest rates, subsequently altering production and consumption However, Bernanke (1983) argues that credit independently influences the economic cycle, introducing a broad credit channel for monetary policy transmission He developed the CC-LM model, which replaces the IS curve with the credit-commodity curve, demonstrating that monetary policy affects economic activity primarily through the credit or bank loan channel For instance, when monetary policy tightens due to rising interest rates, it can reduce bank reserves and deposits, leading to decreased lending to businesses and households.

Bernanke and Blinder (1988) highlighted the significance of the credit channel in monetary policy transmission, proposing that the Bank Lending Channel (BLM) exists under three conditions: loans are not perfect substitutes for private bonds, the central bank can affect bank loans by altering reserves and interest rates, and imperfect price adjustments prevent monetary shocks from being neutral In their 1992 study, they refined this to two essential conditions for BLM: imperfections in credit markets and the imperfect substitutability between bank credit and other external financing sources for certain enterprises When these conditions are met, the central bank can influence bank loan supply, indicating that changes in monetary policy, such as adjustments in short-term interest rates, can impact bank lending if shifts in demand deposits are not fully countered by non-reservable liabilities.

Kashyap and Stein (1995) highlight that the bank lending channel theory relies on two key assumptions: first, that certain expenditures and financing needs depend on bank lending, and second, that monetary policy can influence the supply of bank loans, thereby affecting real aggregate spending When these conditions are satisfied, monetary policy significantly impacts the real economy through the bank lending mechanism (BLM) Specifically, contractionary monetary policy, by raising the policy interest rate, can lead to increased market interest rates and a reduced money supply This results in lower bank deposits and diminished loan availability, ultimately causing a decline in investment, spending, and economic growth (Mishkin, 1996).

Monetary policy transmission through bank loan supply is a key focus in contemporary research (Altunbas et al., 2010; Brissimis and Delis, 2009; Cantero-Saiz et al., 2014; Gambacorta and Marques-Ibanez, 2011; Matousek and Sarantis, 2009; Opiela, 2008) Changes in monetary policy impact both the assets and liabilities of banks For instance, contractionary monetary policy reduces bank reserves, limiting loan availability, which in turn decreases investment spending and overall economic output This process, known as the bank lending mechanism, illustrates how monetary policy affects banks' access to loanable funds, with tighter policies potentially restricting lending operations, while looser policies can enhance them (Bernanke and Blinder).

According to the bank lending channel, contractionary monetary policy reduces reserves and deposits, which are essential for the supply of loanable funds As a result, banks may need to decrease their loan portfolios if they struggle to issue uninsured liabilities to replace the lost loanable funds This view is based on the assumption that changes in policy can significantly impact bank deposits, thereby influencing bank lending.

The Bank Lending Model (BLM) emphasizes the crucial role of commercial banks in providing credit, which is contingent upon the characteristics of borrowers, particularly firms Businesses often depend on these banks for financing, as they may struggle to access credit markets independently If firms rely solely on equity and financial market loans, the necessity for commercial bank loans diminishes, thereby negating the existence of BLM This model underscores that banks are essential to the financial system, as they primarily meet the financing needs of firms Additionally, commercial banks face limitations in financing all assets from deposits alone However, if they can secure non-deposit funds quickly, they can supplement their credit supply without being significantly influenced by monetary policy.

Disyatat (2011) suggests that in a fiat money system with a liberalized financial environment, banks are not limited by deposits for loan supply, as they can access funding from financial markets to meet demand This indicates that credit availability is not solely dependent on deposits Furthermore, monetary policy can impact banks' lending through its effect on their balance sheet strength, rather than just deposit levels When monetary policy tightens, it can weaken banks' leverage and asset quality, increasing their external financing premiums and funding costs, which are then passed on to borrowers (Cantero-Saiz et al., 2014) Consequently, a restrictive monetary policy can lead to a reduction in loanable funds and an increase in financing costs, prompting banks to limit loan supply to both firms and consumers.

Table 2.1 outlines the role of loanable funds as a mediating factor in bank lending mechanisms influenced by monetary policy Changes in monetary policy can impact bank lending through variations in loanable funds, which consist of both deposits and non-deposit funding sources The table details the pathways for each financing source, indicating that shifts in monetary policy may alter the volume of loanable funds, particularly bank deposits, and affect external financing sources As a result, these changes can significantly influence the loan supply available to firms and households.

Table 2.1: Fundamental pathways through which the impact of monetary policy on bank lending is explained

Detailed pathway descriptions according to each loanable fund

The link between bank deposit and loan supply

 Required reserves  Volume of deposits  Credit creation through the multiple impacts  Bank lending

Friedman and Schwartz (1965) and Bernanke and Blinder (1988)

 The yields of bank deposits (compared to other assets)  Households’ willingness to hold bank deposits  Bank lending

The link between bank non-deposit sources of funding and loan

 Changes in financial frictions  Changes in assets available to lend  Bank lending

Detailed pathway descriptions according to each loanable fund

Sources of pathway explanation supply (granted credit is not limited to deposits)

 Changes in the overall risk portfolio of banks  Changes in credit standards

 Changes in risk perceptions of banks and bank balance sheets  Changes in the cost of market funding  Changes in access to funding from financial markets  Bank lending

Disyatat (2011), Gambacorta and Marques-Ibanez

(2011), and Cantero-Saiz et al (2014)

Monetary policy is transmitted through various virtual channels, notably the bank lending channel, which differs from the interest rate channel Understanding these distinctions is crucial for grasping how monetary policy influences the economy The bank lending channel emphasizes the role of banks in facilitating credit, while the interest rate channel focuses on the effects of interest rate changes on consumer and business spending.

Source: Author’s compilation gleaned from previous studies

2.1.3 Empirical research on bank lending mechanism of monetary policy transmission

Numerous studies have investigated the bank lending channel, with Bernanke and Blinder (1988) being a notable early example that utilized aggregate data to assess the effects of monetary transmission on output and money supply However, such research often faces significant identification issues, as it is difficult to ascertain whether changes in lending behavior following monetary policy shifts are due to bank loan supply or driven by loan demand (Kashyap and Stein, 2000) Additionally, the relationship between credit and output over time is complicated by forward-looking expectations and various other factors.

Academicians have increasingly utilized bank-level panel data instead of aggregate data to explore the bank lending channel, revealing its presence primarily in developed countries Studies indicate that the heterogeneity of bank balance sheets significantly influences monetary policy transmission, with effects varying by country Consequently, researchers have employed disaggregated bank data to examine the existence of the bank lending channel.

The developed countries to which the empirical research on the presence of the bank lending channel is mainly devoted (Sanfilippo-Azofra et al., 2018), including the

Research across the US, UK, and Eurozone highlights the significant role of Bank Lending Mechanisms (BLM) in monetary transmission Studies by Altunbaş et al (2002) in Italy and Spain, as well as Huang (2003) in the UK, illustrate how BLM influences banks' lending practices, particularly affecting small, bank-dependent enterprises This consistent finding underscores the importance of BLM in shaping economic dynamics across these regions.

Research indicates that tightening monetary policy can decrease bank loan supply, negatively impacting economic output, while loosening policy can have the opposite effect Kashyap et al (1995) found that monetary policy significantly influences loan supply changes, particularly among small commercial banks However, Ashcraft (2006) questioned the existence of the bank lending channel, noting varied loan supply responses to the Federal Fund Rate among U.S banks When analyzing bank data at the state level, the market share of banks based on loan supply volume appears to mitigate the negative effects of monetary policy changes on loan supply Additionally, the overall elasticity of economic output in relation to bank lending is relatively low and statistically insignificant.

The impact of bank capital on bank loan supply of monetary policy transmission

2.2.1 Introduction to the role of bank capital

 The impact of bank balance sheet items on BLM of monetary policy transmission

The majority of research has used bank-level data proposed by Kashyap and Stein

In 1995, research was conducted to evaluate how bank-specific characteristics and changes in monetary policy jointly affect loan supply Models utilizing bank-level data yield more precise estimates, as the response of lending to monetary policy shifts is influenced by individual bank features and balance sheet strength The bank lending channel exists because, during monetary tightening, banks cannot offset reduced loanable funds through external financing due to information asymmetry and principal-agent issues Information asymmetry often manifests through quantitative indicators, such as asset-based scale and various balance sheet items Consequently, the bank lending channel is closely tied to banks' overall characteristics, including asset-based scale, liquidity, and capitalization.

Empirical evidence from developing economies shows that banks with substantial assets, liquidity, and capitalization are better positioned to lend compared to those with fewer resources These banks can offset reductions in loanable funds by reducing costs and enhancing asset conversion efficiency in response to stricter monetary policies Consequently, the effectiveness of the bank lending channel may diminish.

Research shows that banks with strong balance sheet characteristics can effectively adjust their lending in response to changes in monetary policy Well-capitalized banks with sound liquidity are less affected by unfavorable monetary policy shocks, while those with weaker characteristics struggle to secure uninsured funding due to higher agency costs stemming from information asymmetry between borrowers and lenders Lenders assess a bank's financial health primarily through its financial statements, favoring banks with strong financial indicators for capital allocation Consequently, banks lacking robust characteristics face challenges in accessing external financing due to this information gap During periods of tightening monetary policy, banks with weaker balance sheets may encounter increased unpredictability in their external finance premium, leading to a more significant decline in loan supply Additionally, banks with high credit risk often experience a sharper reduction in lending when monetary policy becomes more restrictive, as their financing costs tend to be elevated.

 Justification for focusing on bank capital

In the wake of the post-2007 financial crisis, bank capital has garnered significant research interest due to its essential function in establishing adequate capital buffers and ensuring stable financial resources, which are vital for sustaining and expanding lending activities Furthermore, the importance of bank capital has been underscored by its role in maintaining lending during the crisis and the regulatory mandates set forth by the Basel Accords.

In Vietnam, a significant portion of banks' total assets is comprised of loans, highlighting the importance of bank lending compared to other institutions in more industrialized economies (Vo, 2018) To enhance profitability and support a sustainable economy, Vietnamese banks are encouraged to prioritize loan expansion However, these banks face challenges due to lower capital levels compared to their global counterparts (Dahir et al., 2019) Currently, they are under pressure to meet Basel capital standards, which increases their vulnerability to economic and policy shocks (Dang, 2019) Consequently, Vietnam aims to establish regulations on bank capital levels while ensuring appropriate lending growth to stimulate the economy (Nguyen and Nguyen, 2022) Notably, the relationship between bank capital levels, monetary policy changes, and the bank lending channel has been largely overlooked in prior research.

This thesis focuses on the impact of bank capital on the bank lending mechanism (BLM) of monetary policy pass-through, while also incorporating other bank-specific factors like liquidity, credit risk, and size into the estimation model to account for their potential effects on bank lending.

2.2.2 Theoretical perspectives for the role of bank capital in driving monetary policy transmission

Monetary policy impacts bank loan supply through two distinct channels influenced by bank capital: the traditional bank lending channel and the bank capital channel Both mechanisms challenge the Modigliani-Miller theory, which posits that a bank's lending decisions should be unaffected by its financial structure in perfect capital markets According to this theory, the amount of bank capital does not influence lending, as banks can always find investors for profitable opportunities However, this assumption fails for specific reasons in each channel, necessitating a separate examination of their unique characteristics.

The BLM hypothesis suggests that monetary policy directly influences the credit supply of bank loans and the real economy, as banks finance loans partly through liabilities tied to required reserves When reserve requirements are enforced, tightening monetary policy can limit banks' capacity to accept reservable deposits, leading to a decrease in lending if they cannot easily shift to alternative financing or sell non-loan assets For the bank lending channel to operate effectively, the market for non-reservable bank liabilities must not be frictionless; otherwise, banks could easily transition to liabilities with lower or no reserve requirements, such as certificates of deposit (CDs), negating the need to forgo profitable lending opportunities due to reserve mandates.

Romer et al (1990) argue that banks can easily shift to non-reservable liabilities, expressing skepticism about the Banking Liquidity Model (BLM) However, Kashyap et al (1995) and Stein (1995) contend that this view, based on Modigliani-Miller logic, overlooks the impact of informational asymmetry on a bank's asset value Stein's model illustrates that adverse selection leads to a "lemon's premium" in the market for riskier bank liabilities Given that most non-reservable bank liabilities are uninsured, they carry moderate risk, and their markets tend to be imperfect.

The BLM operates due to banks' limited liquidity, as the absence of sufficient cash or liquid securities would hinder lending mechanisms Although the description does not address bank capital or capital control, there are important connections between the effectiveness of the BLM and the amount of bank capital available.

Research by Bernanke et al (1991) and Kashyap and Stein (1994a) indicates that the Bank Lending Model (BLM) may be less effective when a significant number of banks have equity at or below the regulatory minimum Banks are unlikely to increase lending without additional capital, especially when capital requirements are tied to risk Furthermore, if issuing risky non-reservable liabilities is costly, then issuing equity, which is the most junior liability, is also expensive.

Adverse selection and moral hazard issues arise in the market for non-reservable bank liabilities, particularly when comparing banks with different liability structures For instance, Bank One, which has a higher debt-to-equity ratio than Bank Two, faces greater risks during a contractionary monetary policy shock that leads to an outflow of reservable deposits Both banks must issue managed liabilities, such as large-denomination CDs, to sustain their lending levels However, Bank One's CDs are riskier due to its lower equity, making it more susceptible to asymmetric information regarding its asset value and resulting in a higher "lemon’s premium." Consequently, Bank One is likely to issue fewer CDs and curtail lending more significantly than the better-capitalized Bank Two following a monetary shock.

The bank capital channel thesis posits that monetary policy affects bank lending through its impact on bank equity capital Van den Heuvel (2002b) developed a model for bank asset and liability management that incorporates the risk-based capital requirements of the Basle Accord and the imperfections in the bank equity market This model reveals that a bank's lending is influenced not only by available lending opportunities and market interest rates but also by its financial structure When equity is insufficient due to loan losses or adverse shocks, banks may reduce lending to meet capital requirements and avoid the costs associated with issuing new equity Additionally, even without capital constraints, banks with low capital may choose to pass on profitable lending opportunities to mitigate the risk of future capital shortfalls.

Research indicates that the heterogeneity of banks significantly influences balance sheet items related to bank lending markets (BLM) Studies by Kashyap et al (1995) and Kishan and Opiela (2006) reveal that smaller banks are particularly vulnerable to the effects of tightening monetary policy due to limited access to alternative funding sources This trend is also observed in banks with lower liquidity and capitalization, as highlighted by various researchers including Altunbaş et al (2002) and Cetorelli and Goldberg (2008).

Highly liquid banks can mitigate the effects of monetary tightening by withdrawing cash and securities, while well-capitalized banks have better access to uninsured financing markets to maintain their loan portfolios Research shows that banks with poor balance sheets are more negatively impacted by monetary restrictions due to their limited ability to find alternative financing when core deposits dwindle Specifically, small, less liquid, poorly capitalized, and high credit risk banks typically experience a greater decline in lending following restrictive monetary policies, whereas their larger, more liquid, well-capitalized, and low credit risk counterparts tend to see an increase in lending during periods of monetary loosening.

The effect of bank competition on bank loan supply of monetary policy

2.3.1 Introduction to the role of bank competition

The market structure of banks has attracted significant interest from both practitioners and scholars due to its impact on competition levels Bank competition influences operational efficiency and can either enhance or hinder the effectiveness of monetary policy, particularly through the bank lending channel Research shows that increased competition in banking often leads to lower prices for financial products and greater access to borrowing (Beck et al., 2004; Cetorelli and Strahan, 2006) However, heightened competition may negatively affect bank management efficiency by shortening loan relationships (Pruteanu-Podpiera et al., 2016) and could prompt banks to adopt riskier behaviors in response to diminishing franchise value (Hellmann et al.).

2000) Kashyap and Stein (1997) underline the need to assess bank concentration, which is a proxy for competitiveness, in order to ascertain the potency of monetary policy

In the aftermath of current crises, a key focus for practitioners and researchers is the role of financial intermediaries in generating new jobs and fostering sustainable growth Market mechanisms, particularly financial competition, significantly influence these objectives Competition can directly or indirectly affect credit supply expansion through the bank lending channel, an area that has been underexplored in prior research While several studies have analyzed banks' responses to monetary policy shocks in relation to various factors, such as ownership structure and risk-taking, the critical role of bank competition warrants further investigation Understanding bank competition is essential for elucidating the competitive dynamics within the banking industry and its impact on the transmission of monetary policy.

2.3.2 Theoretical perspectives for the role of bank competition in determining monetary policy transmission

The financial industry's industrial organization significantly impacts monetary policy transmission, as highlighted by Aftalion and White (1977) and VanHoose (1985) They explore how loan market competition affects the effectiveness of monetary policy and the selection of optimal instruments VanHoose (1983) notably argues that in a competitive banking sector, monetary policy tools like the federal funds rate become ineffective Furthermore, Kashyap and Stein (1997) and Cecchetti (1999) emphasize the importance of banking system concentration and health in assessing monetary policy effectiveness, revealing substantial disparities in banking structures within the Economic and Monetary Union that can lead to varied monetary policy impacts Smaller banks, in particular, may reduce lending during monetary contractions due to weaker balance sheets Baglioni (2007) asserts that the transmission of monetary policy through loan markets is influenced by market structure, with monopolistic competition enhancing policy effects, while oligopolies may diminish them Additionally, Freixas and Rochet (2008) find that increased market competition can reduce banks' sensitivity to changes in monetary policy.

Nations with a high concentration ratio, characterized by a significant presence of larger institutions, experience a diminished impact from the credit channel This analysis suggests that increased concentration aligns with the enhanced efficiency of larger institutions This concept, known as the efficient structure hypothesis, highlights the critical role of effective management and superior production processes in achieving higher profitability and market concentration.

The structure–performance hypothesis posits that banks can achieve monopoly profits in concentrated markets, allowing them to maintain profit-maximizing behaviors despite changes in monetary policy Larger banks, in particular, leverage their market power to extract rents, often delaying the transmission of looser monetary policies while quickly raising lending rates during monetary contractions This results in an asymmetric effect of monetary policy, contrasting with the efficient structure hypothesis, which suggests symmetrical effects for large banks Consequently, the relationship between banking concentration and the effectiveness of monetary policy transmission warrants further investigation, as highlighted by Yamamoto (2020), who indicates that reduced banking competition can diminish the potency of monetary policy.

To some extent, a low level of competition can hamper the potency of monetary policy because concentration leads to a fall in bank loan volume

A recent study highlights that competition significantly influences bank lending, although it operates through various mechanisms Increased competition, particularly from entry restrictions in the banking sector, may eliminate weaker banks that depend heavily on deposits, potentially weakening the bank lending channel Conversely, the policy interest rate impacts the marginal cost of new loans, suggesting that lending is more responsive to these costs in competitive markets Thus, heightened competition can enhance the bank lending channel When other factors are constant, banks with greater market power are likely to access alternative funding sources more easily, indicating that increased competition and reduced market power can strengthen the bank lending channel.

The effectiveness of monetary transmission via the bank lending channel is significantly affected by competition within the banking system Adams and Amel (2005) were the first to empirically assess how local banking market structures impact monetary policy transmission, focusing on small business loans from US banks between 1996 and 2002 Their findings indicate that increased market concentration leads to a deterioration of the lending channel However, this study is limited to local banks in the developed US market In contrast, Gunji et al (2009) conducted a cross-country analysis to explore banks' responses to monetary policy shocks in competitive markets, utilizing a monetary policy indicator derived from an interest rate equation and employing the Panzar–Rosse methodology.

H statistics to evaluate bank competition They discover that competitive markets can buffer bank lending from the influence of monetary shocks

Olivero et al (2011a) found that in Latin American countries with consolidated banking systems, loan supply is less responsive to monetary shocks Their research highlighted the role of market structure in the bank lending channel for monetary policy transmission, revealing that increased competition and consolidation weaken this transmission due to reduced information asymmetries and easier access to alternative funding sources Larger, more competitive banks showed less sensitivity to monetary policy shocks, as their market power allowed them to expand balance sheets without reducing loan supply Amidu and Wolfe (2013) further confirmed that heightened competition in the banking sector lessens the impact of monetary policy on lending in emerging economies Ghossoub and Reed (2015) also identified the optimal size distribution of the banking sector and its influence on monetary policy transmission Additionally, Fungáčová et al (2014) suggested that bank competition can enhance the monetary effect on lending by limiting banks' access to alternative funding sources.

There is a notable lack of empirical research examining how bank competition influences the bank lending mechanism, which may stem from diverse samples and methodologies used to assess competition, as well as differing opinions on the underlying mechanisms According to Olivero et al (2011b), increased bank competition can impact the lending channel in three ways: it may reduce informational asymmetries, enhance the market share of larger banks, or lessen the sensitivity of loan rates to monetary shocks.

Banks with significant market power often exert greater control over financial intermediation by imposing higher interest rates on loans This dynamic influences their operational strategies and overall market behavior, as highlighted by research from Black and Strahan (2002), Cecchetti (2001), and Degryse.

Increased competition among banks can lead to lower loan rates as they strive to attract new borrowers, potentially boosting lending (Ongena, 2005; Ogura, 2006) However, this heightened competition may also reduce banks' charter value, which serves as a self-discipline mechanism to prevent imprudent behavior, such as aggressive lending practices (Hellmann et al., 2000; Repullo, 2004) Ruckes (2004) highlights that profit-maximizing banks may relax credit standards and expand loan availability in response to competition, which could undermine the effectiveness of monetary policy on bank loan supply.

According to Maudos and De Guevara (2007), the conventional Lerner index reveals instances of monopoly power in deposit markets, as banks can secure funds at lower costs When determining loan prices, bank managers consider their funding costs, the risk associated with loan contracts, and a premium for their market power (Yang and Shao, 2016) This framework explains how increased bank competition can weaken the loan growth response to monetary policy Table 2.3 presents empirical studies examining the influence of banking market structure on bank lending margins (BLM).

A study by An et al (2021) on commercial banks in Vietnam found that increased bank competitiveness leads to weaker responses in bank lending to monetary policy changes This phenomenon may be attributed to reduced conversion costs and diminished asymmetric information between banks and customers However, the study has limitations, including a short research period (2008-2017), lack of normalization for bank-specific variables, and limited diversity in competition proxies like the Lerner and Boone indices In contrast, this thesis employs a comprehensive set of competition indicators, such as the Lerner index and Hirschman-Herfindahl Index, and addresses the robustness of findings through nested stepwise regression By overcoming these limitations, the thesis aims to provide innovative insights into the influence of bank competition on the bank lending mechanism (BLM) of monetary policy transmission.

Table 2.3: Empirical research on the bank lending mechanism of monetary policy transmission and banking market structure

The study highlights the vulnerability of lending channels in US banks amid rising market concentration, specifically examining local banks in developed nations.

The author argues that the effectiveness of monetary policy transmission through bank loan markets is influenced by the market structure, indicating that a stronger impact of monetary policy is positively linked to monopolistic competition.

The response of bank loan supply to monetary policy shocks depending on

2.4.1 Introduction to the role of financial development

Over the past two decades, financial systems in many economies have evolved significantly, leading to changes in national policy aimed at enhancing the stability of financial markets While the expansion of financial systems can yield positive economic outcomes, it can also pose challenges, indicating that growth in financial systems does not always correlate with economic growth Importantly, this expansion can impact growth by influencing the monetary policy of central banks.

The financial system plays a vital role in the effectiveness of monetary policy, which seeks to manage key macroeconomic variables influenced by financial advancements It serves as a crucial link between central bank policies and the real economy through the monetary transmission mechanism Changes in the financial system's structure can either disrupt or enhance this mechanism, making the success of monetary policy heavily reliant on the evolving characteristics of the financial system.

Financial development refers to the enhancement of the depth, efficiency, and accessibility of financial institutions and markets, including both banking systems and stock markets (Pradhan et al., 2014) The effectiveness of the bank lending channel relies on financial market imperfections and the degree of financial friction within the economy, indicating that any changes in these factors can influence the monetary transmission mechanism This has led to increased research on the bank lending channel from the perspective of financial development Notably, various studies have shown that the transmission of monetary policy differs significantly across economies (Aysun et al., 2013; Cecchetti, 1999; Elbourne and de Haan, 2006), suggesting that these variations may stem from disparities in financial development.

2.4.2 Theoretical perspectives for the role of financial development in shaping monetary policy transmission

Traditional bank lending models highlight the informational asymmetry between borrowers and lenders, diverging from Modigliani-Miller axioms Borrowers possess private information about their projects, which, while yielding similar returns, have varying success probabilities Limited liability allows borrowers to abandon unsuccessful projects, creating a principal-agent dilemma reflected in debt contracts Consequently, the optimal structuring of financial arrangements in the context of moral hazard leads to notable deviations from Modigliani-Miller principles and underscores the importance of credit in economic fluctuations.

Bernanke, Gertler et al (2007) and Carlstrom and Fuerst (2001) are among the most cited works in the field, highlighting scenarios where adverse economic conditions lead businesses to default on debts They emphasize that limited liability allows debtors to opt for default even in more favorable circumstances Additionally, the high costs associated with "state verification" compel lenders to spend resources to assess whether a default is justified based on the current economic state.

Lenders will consistently require an external financing premium due to the "state verification cost." Consequently, imperfections in the credit market lead firms to prefer investing retained earnings over borrowing funds, as it proves to be more cost-effective.

Bernanke and Gertler (1995) argue that a decrease in bank credit supply can increase the external finance premium, leading to reduced real economic activity For banks to effectively facilitate monetary transmission, some borrowers must depend on them for external financing The fixed costs associated with participating in financial markets often necessitate reliance on banks, which can lower monitoring costs This positions banks as the primary financing source for borrowers unable to issue securities directly Consequently, any shifts in banks' lending behavior will significantly impact these borrowers, establishing a bank lending transmission channel.

Proponents of the bank lending channel argue that monetary policy affects not only the overall interest rates but also the external finance premium This simultaneous change in the external finance premium provides a deeper understanding of the significance, timing, and composition of monetary policy effects, surpassing the insights gained from interest rates alone.

The development of financial markets, particularly the banking sector and capital markets, significantly influences the effectiveness of monetary policy through bank lending According to Gertler and Rose (1994), a more developed banking sector enhances financial intermediation by increasing the size and liquidity of financial institutions, which in turn lowers financial costs and strengthens their balance sheets Furthermore, advancements in capital markets boost overall market liquidity, facilitating increased bank loans and providing banks with greater access to external funding sources As a result, the growth of both the banking sector and capital markets diminishes the impact of monetary policy through the bank lending channel.

By and large, research on the impact of financial development on the propagation of monetary policy via BLM remains overlooked For more details, Carranza et al

Research indicates that monetary policy significantly impacts financial systems in less developed countries (2010) Cantero-Saiz et al (2014) found that the lending channel is more effective in nations with higher sovereign risks, which may correlate with a country's ability to access international financial markets (Rebelo et al., 2018) Studies on developing economies reveal that an underdeveloped money market can limit banks' credit supply responsiveness during tighter monetary conditions (Archer, 2006a; De Mello and Pisu, 2010; Hou and Wang, 2013) Lerskullawat (2017) suggests that the growth of the banking industry and capital markets may reduce reliance on bank loans, thereby weakening the bank lending channel This financial development can diminish the impact of monetary policy on bank loan supply growth due to limited external financing opportunities Sanfilippo-Azofra et al (2018) found that increased financial development amplifies the negative effects of tightening monetary policy through the bank lending channel in 31 developing economies.

The efficiency of the bank lending channel is influenced by the level of financial development, particularly in the early stages when banks may struggle with capital scarcity Many individuals prefer to keep their savings at home rather than depositing them in banks, limiting the banking system's ability to gather significant funding (Freedman and Click, 2006) Furthermore, individuals and small to medium-sized enterprises often face challenges in accessing credit due to a lack of sufficient collateral, making them less likely to repay loans This situation hinders their ability to secure financing from banks (Rajan and Zingales, 2004), resulting in banks having inadequate funding sources to support their liabilities, such as short-term loans.

As financial growth advances, monetary policy increasingly impacts bank lending In mature financial systems, capital becomes more abundant, allowing households and businesses that once struggled to access credit to benefit significantly.

In the early stages of financial market development, banks play a crucial role in the economy, serving as the primary means of financial intermediation During this period, most economic agents rely heavily on bank savings as their main financial asset Additionally, since deposits are the key source of funding for banks, a restrictive monetary policy can lead to a notable decrease in loan availability due to its significant impact on bank deposits.

In a well-developed financial system, banks possess a diverse range of financial instruments to mitigate monetary shocks, thereby reducing the impact of the bank lending channel Consequently, these banks remain a significant source of external financing for non-financial enterprises.

As new market participants and innovative products emerge, the traditional banking role of collecting deposits and extending credit may decline Financial innovation enhances banks' intermediation functions, allowing them to originate, repackage, and sell loans in financial markets This development seems to reduce the impact of monetary policy changes on loan supply.

Chapter summary

Bernanke and Blinder (1992) highlight that macroeconomic time series are inadequate for identifying the bank lending mechanism, which consists of sub-channels of credit channels, due to the inability to distinguish between supply-side and demand-side variables affecting bank lending This presents a significant identification challenge when relying on aggregate data In contrast, utilizing disaggregated bank-level data can effectively reveal the distributional effects of monetary policy via the lending channel and the impact of various bank-related factors Acknowledging this limitation, the current thesis examines a disaggregated dataset of Vietnamese commercial banks to explore the effects of bank heterogeneity, including bank capital, competition, and financial development on the bank lending mechanism in the context of monetary policy transmission.

Shifts in monetary policy can significantly impact bank loan supply through the bank lending channel The Bank Lending Model (BLM) highlights the relationship between bank lending and deposits as a unique category of loanable funds When the central bank tightens liquidity using interest rate-based tools, banks are forced to rely more on non-reservable or uninsured funding sources instead of reservable or insured funds This situation is exacerbated for banks with weak balance sheets, as they face challenges in securing uninsured funding due to elevated agency costs in the deposit market.

Uninsured funds may face adverse selection and credit rationing, leading to significant risks for these financial resources (Stein, 1995) Consequently, banks with uninsured funds are less likely to compensate for the absence of financing, resulting in a reduction of loan issuance This situation ultimately forces them to limit lending to economic agents that rely on bank financing.

To establish the presence of the Bank Lending Channel (BLM) in Vietnam, it is crucial to first validate a primary hypothesis using updated data and a normalized approach to bank balance sheet items, along with essential control variables Building on this baseline model, further hypotheses will be formulated by integrating additional significant factors such as bank capital, competition, and financial development This extended model aims to explore the interactions between these factors and monetary policy indicators, thereby assessing the influence of bank competition, capital levels, and the overall development of financial markets on the BLM.

The responsiveness of bank loans to monetary policy changes varies based on the strength of a bank's balance sheet, with banks that have poor balance sheets being more susceptible to monetary shocks This article emphasizes the importance of bank capital, which plays a crucial role in maintaining stability within the banking system Undercapitalized banks are perceived as riskier by market participants, leading to higher costs for external credit Consequently, these banks struggle to secure financing in capital markets to maintain their loan portfolios, resulting in a significant reduction in lending during periods of monetary tightening.

Most studies on Bank Lending Models (BLM) consider bank capital as infinite values for continuous variables However, creating interaction terms between bank capital and monetary policy proxies fails to capture the dynamics between different monetary policy regimes, such as loosening versus tightening, and how these regimes affect bank lending based on varying capital levels.

This thesis seeks to address the underutilization of interactive terms among continuous variables by incorporating squared interactive terms into econometric marginal analysis, complemented by plot illustrations This approach is notably rare in empirical studies related to BLM, highlighting a significant gap in the existing literature.

Research has investigated the relationship between banking concentration and competitive ability, particularly in relation to monetary policy pass-through Adams and Amel (2005) were pioneers in linking the bank industry's market structure to the effectiveness of monetary policy, finding that increased bank competitiveness diminishes the impact of monetary policy on lending A concentrated banking market tends to make banks less vulnerable to monetary shocks, as they benefit from more favorable financing conditions However, evidence regarding the influence of bank competition on bank lending mechanisms remains mixed.

Financial development is a recent focus in empirical research on the bank lending mechanism (BLM) of monetary policy transmission This aspect has gained attention, particularly in the context of ASEAN, as highlighted by Lerskullawat (2017).

A study by Sanfilippo-Azofra et al (2018) across five countries suggests that the weakening effect of monetary policy may be more pronounced in European banks In more developed financial systems, shifts in monetary policy tend to have a diminished impact on bank loan supply This is attributed to banks having access to a wider array of financial instruments and funding sources, which helps them mitigate the effects of monetary policy shocks.

This chapter outlines the key components of monetary policy transmission, including definitions and primary factors influencing it It reviews both theoretical and empirical literature on factors that significantly impact bank lending mechanisms (BLM), with a focus on developing economies, particularly Vietnam, which is expected to follow similar trends The chapter emphasizes the role of the bank lending channel, influenced by a bank's market structure and capital levels Research hypotheses are proposed to examine the nonlinear effects of bank capital on loan growth in response to monetary policy changes, as well as the distributional impacts of bank competition and financial development on BLM The conceptual research framework and corresponding hypotheses are presented below.

Monetary policy implementation Bank loan supply Bank-lending channel

RESEARCH DATA AND METHODOLOGY

EMPIRICAL FINDINGS AND DISCUSSION

CONCLUSION