Borrowers’ Financial Constraints and the Transmission of Monetary Policy: Evidence from Financial Conglomerates∗

Exploring the functioning of internal capital markets in financial conglomerates, this paper conducts a novel test of the credit channel of monetary policy. We look at how the response of lending to monetary policy shocks differs across small banks that are affiliated with the same bank holding company but that operate in distinct geographical areas. These subsidiaries tap into the same pool of funds but face different pools of borrowers. Because small subsidiary banks concentrate their lending with small local businesses (whose fortunes are tied to their local economies), we can exploit cross-sectional differences in local economic conditions at the time of a monetary policy shock to study whether the strength of borrowers’ balance sheets influences the response of bank lending to policy. We find evidence that the negative response of bank loan growth to a monetary contraction is significantly more pronounced when borrowers are more likely to have weaker balance sheets. Our results are consistent with the operation of a demand-driven transmission mechanism that works independently of the bank-supply (“lending”) channel. In fact, our estimates suggest that borrowers’ balance sheet strength accounts for a significant fraction of the broad “credit channel” of monetary policy. JEL Codes: E50, E51, G22.