Does the Lack of Financial Stability Impair the Transmission of Monetary Policy?

We investigate the transmission of central bank liquidity to bank deposit and loan spreads in Europe over the January 2006 to June 2010 period. We find evidence consistent with an impaired transmission channel due to bank risk. Central bank liquidity does not translate into lower loan spreads for high-risk banks, even as it lowers deposit rates for both high-risk and low-risk banks. This adversely affects the balance sheets of borrowers of high-risk banks, leading to lower payouts, lower capital expenditures, and lower asset growth. These firms replace term loans drawing down existing credit lines. Our results suggest that during a banking crisis, the transmission of central bank liquidity to the real sector may be more effective if accompanied by a strengthening of banking sector health.