bank lending rates in these countries tracked the ECB’s main refinancing rate closely. A recent study of the Portuguese experience (Iyer et al, 2014) finds that bank fundamentals have amplified the impact of liquidity shocks. Moreover, banks that were more stressed tended to hoard the additional liquidity provided by the ECB.<sup>56</sup> During the freeze of the European interbank market, banks that relied more on interbank borrowing before the crisis decreased their credit supply, particularly towards smaller and younger firms with weaker banking relationships (as measured by credit volume before the crisis).<sup>57</sup> They also find that this period of bank illiquidity had a stronger effect on credit supply in banks that had a higher ratio of non‐performing loans. In situations of high debt, the pass‐through of monetary policy is also affected (see debt section). In a study of US banks, Santos (2011) found that loan spreads increased more for banks with larger losses and those which faced higher capital requirements. Another study (Di Maggio et al 2016) demonstrates that the transmission of unconventional monetary policy depends critically on the assets purchased and on the segmentation of asset markets. For example, significant purchases of certain mortgage classes increased mortgage originations in that class. Moreover, there were important complementarities between monetary policy and macroprudential housing policy. A recent study of low productivity growth in the UK cites bank forbearance as a channel by which delayed financial sector restructuring may distort resource allocation between firms (see also Caballero et al 2008) and dampen the productivity enhancing effects of job reallocation (Riley et al 2015). These experiences indicate that policy makers must actively address structural aspects of a country’s financial (and fiscal) system at the same time as monetary policy is changed in order to maximize the intended effect of monetary policy (see also discussion below).

**Lesson 8: Stabilization is only the first step in crisis recovery; distributional effects‐the condition of smaller firms and households‐ matter for a faster recovery.**

_<u>In financial crises, stabilization of the large financial institutions and of public finances is a critical first step only; swift, active debt restructuring is necessary in situations of debt overhang. Simply dealing with large players’ debt will not hasten recovery as deteriorated balance sheets of small banks and firms, and households, can together be large and retard the recovery.</u>_ _<u>Active stabilization and smaller financial sectors.</u>_ Since 2008‐09, Ireland has restructured, recapitalized and downsized its domestic banks, liquidating the banks that were insolvent so that domestic banking sector assets fell from 305% of GDP at end‐2010 to 138% of GDP in 2014. Foreign banking collapsed in Ireland – deposit money banks’ assets fell from 179% of GDP in 2009 to 103% in 2014. At the same time, Ireland’s public debt ratio jumped as the government recapitalized banks.<sup>58</sup> Greece lost most of its foreign banking‐ these assets fell from 44% to 6% of GDP (Figure 11). The decline in foreign banking was lower in Spain and Portugal and the sector was small to begin with (fell from 30% of GDP to 22%, and from 62% to 51% respectively). Domestic credit to the private sector as a ratio of GDP fell in all countries during 2009‐14 except in Greece where the decline in GDP was faster.<sup>59</sup> When credit from _domestic_ banks only is considered, Ireland, with its very large financial sector, tops the list with a 50% decline in real credit outstanding, followed by Spain with a 36% decline in credit; G and P, with less of a financial sector led boom pre‐2009, had lower declines (25%).<sup>60</sup>

> 56 There is both a theoretical literature and recent empirical literature that shows that banks hoard liquidity during crisis periods, e.g., Acharya et al 2011, 2012.

> 57 A 10% higher interbank borrowing before the crisis leads to a further 4% reduction in firm credit availability during the crisis.

> 58 The non‐bank financial sector, the largest in Ireland, also collapsed.

> 59 Typically credit growth is expected to lag the recovery in economic activity, even though narrower monetary aggregates may recover.

> 60 Considering credit from all sources, a somewhat different picture is presented. In this case, credit outstanding is fairly stable for Ireland and falls the most for Greece.

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