The credit channel assigns an active role to the supply of loans in the monetary
policy transmission process. It captures the bank lending and balance sheet
effects (broad credit channel) of a policy-induced change in short-term nominal
interest rates. In this channel, the traditional cost-of-capital channel (i.e.,
interest rate channel) is amplified and propagated by how changes in policy
rates affect the availability and cost of credit. Research on the credit channel
picked up considerably starting the 1990s when concerns about credit crunch
were widespread.
The bank lending channel is premised on the fact that banks play a special
and central role in the financial system because they are well suited to solve
asymmetric information problems in credit markets. Some borrowers (including
small- and medium-sized enterprises and households) are very dependent on
bank financing and can only access credit markets through bank borrowings.
The broad credit channel focuses on all forms of external finance that firms
can tap but at a cost premium. This external finance premium compensates
lenders for the monitoring and evaluation of loans and is affected by the stance
of monetary policy. Monetary tightening raises the external finance premium
of all funds. This affects a borrower’s balance sheet in at least two ways. one,
higher interest rates raise interest expense, reducing the borrower’s net cash
flow and weakening its financing position.Two, higher interest rates shrink
the value of the borrower’s collateral since these are typically associated with
declining asset prices. In both cases, the decline in the borrower’s net worth
leads to a fall in investment and aggregate demand.