03 May 2019

ECB: Monetary policy, credit institutions and the bank lending channel in the euro area

This paper provides an overview of developments in the euro area banking sector and of how monetary policy – both standard and non-standard – has been transmitted through banks to the non-financial private sector.

The euro area private sector relies predominantly on banks for its external financing, and because changes in bank capital, profitability, funding and asset quality can alter banks’ credit intermediation capacity, it is essential to monitor developments in these variables.

Since the inception of the euro, banks’ assets and liabilities have not only reflected, but also affected, developments in the macroeconomy. In the run-up to the financial crisis, banks’ asset growth was driven by credit to the private sector and expansion of external assets. Subsequently, there were two distinct waves of active balance sheet deleveraging during the financial crisis. External assets decreased strongly in the early stages, and then almost all asset components contracted as the sovereign bond crisis intensified towards the end of 2011.

On the liabilities side, outflows during the crisis were mainly in debt securities and interbank and external funding, and banks increasingly relied on central bank funding. The share of more stable funding sources, such as euro area residents’ deposits, has increased since the crisis.

Authors also show that there is heterogeneity across banks’ balance sheets according to their business models and strategies, which are also relevant for how banks transmit monetary policy through to firms and households.

The banking sector’s primary function of channelling funds from savers to productive firms and households is essential to ensuring investment and growth, but it can be an opaque and risky activity. For this reason, it is essential to monitor banks’ risk-bearing capacity to ensure a healthy flow of lending to the real economy. Shocks to banks’ risk-bearing capacity can curtail credit supply and therefore may require a monetary policy response.

Authors provide an overview of the main indicators of banks’ capacity to intermediate and to absorb shocks. Since the onset of the financial crisis, euro area banks have increased their regulatory capital ratios, making them more resilient to shocks. Moreover, they show that credit risk in banks’ balance sheets is decreasing as macroeconomic conditions steadily brighten. This is manifested by the reduction in the stock of non-performing loans (NPLs), meaning that their adverse effect on credit conditions is diminishing.

Bank profitability affects their ability to generate capital and therefore may impact their capacity to provide adequate funding to the economy. Authors show that euro area banks’ profitability has been gradually recovering from the significant decline that followed the crisis, though it remains low by historical standards. In recent years, net interest income has remained broadly unchanged, with lower interest income fully offset by lower interest expense. Overall, universal banks seem to have fared better, perhaps reflecting benefits in terms of their diversification.

Finally, they analyse the transmission of monetary policy through to interest rates, credit volumes and bank profits.

Working paper

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