# A. Bank lending channel

The bank lending channel, also referred to as the narrow credit channel, arises from the special role played by banks in credit extension. As explained in the previous section, certain asymmetric information problems are more likely to be prevalent among households and small firms. This can limit their access to financial services, even when households have adequate income or when firms have projects with reasonably high risk-adjusted returns. Banks invest in information acquisition and monitoring and can thereby (partially) overcome the problems arising from information asymmetry (and other “contracting” problems).<sup>26</sup> However, during this process, some households and smaller firms may become bank-dependent in that they are unable to substitute with ease other forms of finance for bank loans (or whatever financial services they obtain from a bank). Larger firms, by contrast, may be less affected by such lock-in effects because they are less subject to information asymmetries and do not depend as much on banks. In addition to retained earnings, they can finance investment by issuing equities and bonds in capital markets or by raising other forms of external financing.<sup>27</sup> Liquidity provision, which takes the form of credit lines and backup facilities (targeted at firms and including capital market instruments, such as commercial paper) is another reason for the special role of banks. Indeed, banks play a special role in maturity transformation and liquidity provision (see Diamond and Dybvig (1983) and Holmström and Tirole (1997)). The traditional function of a bank is to borrow short (eg collect households deposits) and lend long (eg extend loans to firms and mortgages to households). In doing so, a bank provides valuable external financing. Banks also provide liquidity services to firms and households. Through the raising of wholesale funds, for example, a bank can quickly make liquidity available to corporations. Although other financial institutions perform similar functions, the ability of banks to provide liquidity at short notice is not easily matched by other forms of financial intermediation.

The dependence of firms and households on banks for credit and liquidity has consequences for the real economy. Since some firms and households cannot easily substitute for bank loans and liquidity, banks play a central role in the propagation of economic fluctuations. Real and financial shocks affecting banks’ ability to lend and provide liquidity then influence the real sector. Shocks can arise from changes in regulation, supervision, technology or preferences. For example, a regulatory change can require banks to keep higher reserves. If they cannot raise funds quickly, banks may need to adjust their lending, an adjustment that is more likely to affect bank-dependent borrowers, such as smaller firms and households. When faced with an adverse shock, a change in lending is also more likely for small banks because of their limited access to other forms of funding (such as certificates of deposit). Since such banks are also more likely to have a higher proportion of bank-dependent clients, it can again disproportionally affect smaller firms and households.

26 Many studies examine the special roles of banks (Freixas and Rochet (2008) and BCBS (2016) review the literature). For example, banks can screen potential borrowers, acquire information on firms’ collateral (Rajan and Winton (1995) and Diamond and Rajan (2001)) or directly monitor borrowers’ actions in order to prevent problems associated with moral hazard (Repullo and Suarez (2000) and Holmström and Tirole (1997)). Earlier contributions include Brunner and Meltzer (1963) and Bernanke (1983), and Rajan (1998) provides a comprehensive review of the functions of banks.

27 Bernanke and Blinder (1988) provide a stylised discussion of the lending channel using an IS/LM type framework. Stein (1998) provides a “micro-founded” adverse selection model of bank asset and liability management that generates a lending channel. For an early overview of the theory and empirical evidence relating to the bank lending channel, see Kashyap and Stein (1994).

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