Sovereign Risk and Cross-Country Heterogeneity in the Transmission of Monetary Policy to Bank Lending in the Euro Area

Abstract

Is the transmission of monetary policy to bank lending heterogeneous across euro area countries? is paper employs annual bank level data to test whether the bank lending channel of monetary policy was heterogeneous in the euro area over the period 2007-2016. To do so it follows a simple procedure that allows direct testing of how monetary policy a ected similar banks located in di erent countries. Results indicate that the transmission of monetary policy to bank lending was heterogeneous across countries that were di erently exposed to the sovereign debt crisis. On average, the same 1% cut in the policy rate led to a 1.6% increase in lending by banks located in non-stressed countries as opposed to a 0.4% increase for banks located in countries under severe sovereign stress. Unconventional monetary policy -as captured by the ECB shadow rate -was also unevenly transmi ed to bank lending. Exposure to sovereign risk is identi ed as a key source of heterogeneity. Within stressed countries, banks with larger sovereign exposures reacted to monetary easing by expanding lending by less than banks with smaller exposures. As a result, monetary accommodation was smoothly transmi ed to lending only by banks with limited exposure to sovereign risk. In response to the same 1% policy rate cut, the credit expansion of highly exposed stressed countries banks was instead 2.75% weaker than that of banks in non-stressed countries.ese ndings support existing evidence on sovereign risk having direct adverse consequences for bank lending and highlight the extent to which sovereign risk aggravated heterogeneities in the transmission on monetary policy to the real economy via the banking system during the euro area debt crisis.

State-level Taylor rule and monetary policy stress

“…More recently, the overall heterogeneity in reactions to single monetary policy in Eurozone is confirmed by Mandler et al (2022) and Almgren et al (2022), while Grandi (2019) provides evidence of asymmetries in the transmission and monetary framework across members. Indirect evidence of possible problems with adequacy of single monetary policy is provided by Syed (2021), who shows striking differences in the expectations adjustments following monetary policy changes in two core Eurozone member states: Germany and France.…”