Under the Damocles Sword: The Bank Lending Channel in a Transition Economy

Abstract

This paper builds on the seminal works of Kashyap and Stein (1995) and Bernanke and Blinder (1988) and develops a two-model strategy to assess the bank lending channel of monetary policy transmission in Azerbaijan – a small transition economy. Both models comfortably confirm the existence of the bank lending channel. Smaller, less capitalized banks with lower levels of liquidity exhibit better responses to monetary shocks. The newly introduced characteristic of “profitability” appears to be very relevant, since monetary policy is consistently more powerful for less profitable banks. Concentration analysis concludes that monetary policy is less effective when consolidation intensifies and raises the issue of the negative role that systemic banks play in monetary policy transmission. An extension of the direct effects model with asymmetric policy shocks reveals that small banks get affected by both monetary policy expansions and contractions more than larger banks. The new assumption of imperfect competition is introduced to the conventional loan supply function by assuming heterogeneous lending schedules across banks, which is far more realistic for a transition economy set-up. This leads to systematically smaller estimates, implying that efficacy of the bank lending channel in transition economies is attenuated by imperfect competition in domestic financial markets. In addition, central bank notes are substituted for the more commonly used government t-bills but results do not alter substantially. In the end, sectoral analysis reveals that the bank lending channel is most effective for consumer loans and least effective for industrial loans.