Bank lending, collateral, and credit traps in a monetary union

Abstract

This paper studies the transmission of non-standard monetary policy to firms’ investment in a monetary union where financial frictions limit the access to external finance. The model incorporates a sovereign-banking nexus where the occurrence of sovereign default severely hits the balance sheet of domestic banks. This feature impairs monetary transmission, generating responses of lending that diverge across countries, as well as the risk of cross-border spillover effects. Specifically, I show that the liquidity injected into the stressed country’s banks can result in financing the sovereign rather than boosting lending. Moreover, sovereign risk in one country can reduce asset values and, via the collateral channel, depress lending throughout the monetary union. The model sheds light on the troubled transmission of the ECB’s policy measures to the economy of stressed countries during the European sovereign debt crisis.