Monetary Policy Exposure of Banks and Loan Contracting

Abstract

The bank lending channel states that tight monetary policy impairs the loan supply of banks to borrowers. However, banks and their borrowers enter into binding long-term loan contract agreements, limiting the ability of banks to decrease loan supply. This raises the question of whether banks take ex ante actions to gain flexibility to reduce their lending when needed. In this paper, I exploit banks’ heterogeneity of exposure to monetary policy and show that banks with higher exposure write stricter covenants in their loan contracts. This practice of writing stricter covenants increases the probability of covenant violation, and hence enables banks to decrease loan amounts to their existing borrowers during times of monetary policy tightening. The results are robust after controlling for endogenous bank-borrower matching, by having a within borrower estimation or using bank mergers as an instrument. Consistent with the increased incentive and ability of banks, the effect is stronger for long-term lines of credit originated to financially constrained firms during times of high monetary policy uncertainty. These findings show how banks preserve flexibility against future contingencies, and highlight the role of a specific feature of financial contracting in the transmission of monetary policy to the economy through banks.