Credit channel
Encyclopedia
The credit channel mechanism of monetary policy
describes the theory that a central bank's policy changes affect the amount of credit that banks issue to firms and consumers for purchases, which in turn affects the real economy.
, focus on direct effects of monetary policy actions. The interest rate channel, for example, suggests that monetary policy makers
use their leverage over nominal, short-term interest rates, such as the federal funds rate
, to influence the cost of capital
, and subsequently, purchases of durable good
s and firm investment. Because prices are assumed to be sticky in the short-run, short-term interest rate
changes affect the real interest rate
. Changes in the real interest rate
influence firm investment and household spending decisions on durable good
s. These changes in investment and durable good
purchases affect the level of aggregate demand
and final production.
By contrast, the credit channel of monetary policy transmission is an indirect amplification mechanism that works in tandem with the interest rate channel
. The credit channel affects the economy by altering the amount of credit firms and/or households have access to in equilibrium. Factors that reduce the availability of credit reduce agents' spending and investment, which leads to a reduction in output. In short, the main difference between the interest rate channel and the credit channel mechanism is how spending and investment decisions change due to monetary policy changes.
adjustments that affect the short-term interest rate
are amplified by endogenous changes in the external finance premium The external finance premium is a wedge reflecting the difference in the cost of capital internally available to firms (i.e. retaining earnings
) versus firms' cost of raising capital externally via equity and debt markets. External financing is more expensive than internal financing and the external finance premium will exist so long as external financing is not fully collateralized. Fully collateralized financing implies that even under the worst case scenario the expected payoff
of the project is at least sufficient to guarantee full loan repayment. In other words, full collateralization means that the firm who borrows for the project has enough internal funds relative to the size of the project that the lenders assume no risk. Contractionary monetary policy
is thought to increase the size of the external finance premium, and subsequently, through the credit channel, reduce credit availability in the economy.
The external finance premium exists because of frictions—such as imperfect information
or costly contract enforcement—in financial markets. The frictions prohibit efficient allocation of resources and result in dead-weight cost
. For example, lenders may incur costs, also known as agency cost
s, to overcome the moral hazard
problem that arises when evaluating the credit worthiness of borrowers. Moral hazard
in this context refers to the notion that borrowers who need access to credit may be those who are least likely to be able to repay their debts. Additionally, lenders may incur a monitoring cost regarding the productive uses to which the borrowers have put the borrowed funds. In other words, if the ability to repay a loan used to finance a project is dependent on the project's success—either 'good' or 'bad' for simplicity—borrowers may have the incentive to claim the project was 'bad'. If the true value of the project is only known to the borrower, the lender must incur a monitoring or auditing cost in order to reveal the true project returns and receive full re-payment.
The size of the external finance premium that results from these market frictions may be affected by monetary policy actions. The credit channel—or, equivalently, changes in the external finance premium—can occur through two conduits: the balance sheet channel and the bank lending channel. The balance sheet channel refers to the notion that changes in interest rates affect borrowers' balance sheets and income statement
s. The bank lending channel refers to the idea that changes in monetary policy may affect the supply of loans dispersed by depository institutions.
to put up against the funds they need to borrow, and thus are closer to being fully collateralized than low net worth agents. As a result, lenders assume less risk when lending to high net worth agents, and agency cost
s are lower. The cost of raising external funds should therefore be lower for high net worth agents.
Since the quality of borrowers' financial positions affect the terms of their credit, changes in financial positions should result in changes to their investment and spending decisions. This idea is closely related to the financial accelerator
. A basic model of the financial accelerator suggests that a firm's spending on a variable input cannot exceed the sum of gross cash flows and net discounted value
of assets. This relationship is expressed as a "collateral-in-advance" constraint. An increase in interest rates will tighten this constraint when it is binding
; the firm's ability to purchase inputs will be reduced. This can occur in two ways: directly, via increasing interest payments on outstanding debt or floating-rate debt, and decreasing the value of the firm's collateral through decreased asset
-prices typically associated with increased interest rates (reducing the net discounted value
of the firm's assets); and indirectly, by reducing the demand for a firm's products, which reduces the firm's revenue while its short-run fixed cost
do not adjust (lowering the firm's gross cash flow). The reduction in revenue relative to costs erodes the firm's net worth and credit-worthiness over time.
The balance sheet channel can also manifest itself via consumer spending on durables
and housing. These types of goods tend to be illiquid
in nature. If consumers need to sell off these assets to cover debts they may have to sell at a steep discount and incur losses. Consumers who hold more liquid financial assets such as cash, stock
s, or bonds
can more easily cope with a negative shock
to their income. Consumer balance sheets with large portions of financial assets may estimate their probability
of becoming financially distressed as low and are more willing to spend on durable goods and housing. Monetary policy changes that decrease the valuation of financial assets on consumers' balance sheets can result in lower spending on consumer durables and housing.
credit, especially credit extended through commercial banks. The bank lending channel is essentially the balance sheet channel as applied to the operations of lending institutions. Monetary policy actions may affect the supply of loanable funds
available to banks (i.e. a bank's liabilities), and consequently the total amount of loans they can make (i.e. a bank's asset
s). Banks serve to overcome informational problems in credit markets by acting as a screening agent for determining credit-worthiness. Thus many agents are dependent on banks to access credit markets. If the supply of loanable funds
banks possess is affected by monetary policy changes, then so too should be the borrowers who are dependent on banks' funds for business operations. Firms reliant on bank credit may either be shut off from credit temporarily or incur additional search cost
s to find a different avenue through which to obtain credit. This will increase the external finance premium, consequently reducing real economic activity.
The bank lending channel presumes that monetary policy changes will drain bank deposits so long as banks cannot easily replace the short-fall in deposits by issuing other uninsured liabilities. The abolition of reserve requirements on certificates of deposit in the mid-1980s made it much easier for banks facing falling retail deposits to issue new liabilities not backed by reserve requirements. This is not to say that the bank lending channel is no longer relevant. On the contrary, the fact that banks can raise funds through liabilities that pay market interest rates exposes banks to an external finance premium as well. Forms of uninsured lending carry some credit risk relative to insured deposits. The cost of raising uninsured funds will reflect that risk, and will be more expensive for banks to purchase.
Since the credit channel operates as an amplification mechanism along side the interest rate effect, small monetary policy changes can have large effects if the credit channel theory holds. Asset price boom and bust patterns in the 1980s may have led to the subsequent real fluctuations observed in many advanced economies. It has also been found that small firms, who are credit constrained relative to larger firms, respond to cash flow squeezes by cutting production and employment. Large firms, by contrast, respond to cash flow squeezes by increasing their short-term borrowing. Moreover, this empirical result still holds when controlling for industry characteristics and financial criteria. Recent research at the Federal Reserve suggests that the bank lending channel manifests itself through the mortgage lending
market as well. Monetary policy tightening
may force banks to shift from retail deposits
insured by the Federal Deposit Insurance Corporation
to uninsured managed liabilities if they wish to continue financing mortgages. This will increase banks' external finance premium. Banks who lend heavily in sub-prime
communities will face higher external finance premiums because the risk from holding assets composed largely of subprime borrowers is relatively high. As a result, banks have to raise funds through instruments that offer higher interest payments. The empirical evidence suggests that banks that lend heavily in subprime communities and rely mostly on retail deposits reduce mortgage issuance relative to other banks in the face of a monetary contraction. No evidence was found of reductions in mortgage lending initiating from other banks who do not lend heavily in subprime communities or who do not rely heavily on retail deposits in response to monetary policy tightening.
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
describes the theory that a central bank's policy changes affect the amount of credit that banks issue to firms and consumers for purchases, which in turn affects the real economy.
Credit channel versus conventional monetary policy transmission mechanisms
Monetary policy transmission mechanisms describe how policy decisions are translated into effects on the real economy. Conventional monetary policy transmission mechanisms, such as the interest rate channelMonetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
, focus on direct effects of monetary policy actions. The interest rate channel, for example, suggests that monetary policy makers
Federal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...
use their leverage over nominal, short-term interest rates, such as the federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
, to influence the cost of capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
, and subsequently, purchases of durable good
Durable good
In economics, a durable good or a hard good is a good that does not quickly wear out, or more specifically, one that yields utility over time rather than being completely consumed in one use. Items like bricks or jewellery could be considered perfectly durable goods, because they should...
s and firm investment. Because prices are assumed to be sticky in the short-run, short-term interest rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
changes affect the real interest rate
Real interest rate
The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
. Changes in the real interest rate
Real interest rate
The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
influence firm investment and household spending decisions on durable good
Durable good
In economics, a durable good or a hard good is a good that does not quickly wear out, or more specifically, one that yields utility over time rather than being completely consumed in one use. Items like bricks or jewellery could be considered perfectly durable goods, because they should...
s. These changes in investment and durable good
Durable good
In economics, a durable good or a hard good is a good that does not quickly wear out, or more specifically, one that yields utility over time rather than being completely consumed in one use. Items like bricks or jewellery could be considered perfectly durable goods, because they should...
purchases affect the level of aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
and final production.
By contrast, the credit channel of monetary policy transmission is an indirect amplification mechanism that works in tandem with the interest rate channel
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
. The credit channel affects the economy by altering the amount of credit firms and/or households have access to in equilibrium. Factors that reduce the availability of credit reduce agents' spending and investment, which leads to a reduction in output. In short, the main difference between the interest rate channel and the credit channel mechanism is how spending and investment decisions change due to monetary policy changes.
How the credit channel works
The credit channel view posits that monetary policyMonetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
adjustments that affect the short-term interest rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
are amplified by endogenous changes in the external finance premium The external finance premium is a wedge reflecting the difference in the cost of capital internally available to firms (i.e. retaining earnings
Retained earnings
In accounting, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or...
) versus firms' cost of raising capital externally via equity and debt markets. External financing is more expensive than internal financing and the external finance premium will exist so long as external financing is not fully collateralized. Fully collateralized financing implies that even under the worst case scenario the expected payoff
Expected value
In probability theory, the expected value of a random variable is the weighted average of all possible values that this random variable can take on...
of the project is at least sufficient to guarantee full loan repayment. In other words, full collateralization means that the firm who borrows for the project has enough internal funds relative to the size of the project that the lenders assume no risk. Contractionary monetary policy
Contractionary monetary policy
Contractionary monetary policy is monetary policy that seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry....
is thought to increase the size of the external finance premium, and subsequently, through the credit channel, reduce credit availability in the economy.
The external finance premium exists because of frictions—such as imperfect information
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
or costly contract enforcement—in financial markets. The frictions prohibit efficient allocation of resources and result in dead-weight cost
Deadweight loss
In economics, a deadweight loss is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal...
. For example, lenders may incur costs, also known as agency cost
Agency cost
An agency cost is an economic concept that relates to the cost incurred by an entity associated with problems such as divergent management-shareholder objectives and information asymmetry...
s, to overcome the moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
problem that arises when evaluating the credit worthiness of borrowers. Moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
in this context refers to the notion that borrowers who need access to credit may be those who are least likely to be able to repay their debts. Additionally, lenders may incur a monitoring cost regarding the productive uses to which the borrowers have put the borrowed funds. In other words, if the ability to repay a loan used to finance a project is dependent on the project's success—either 'good' or 'bad' for simplicity—borrowers may have the incentive to claim the project was 'bad'. If the true value of the project is only known to the borrower, the lender must incur a monitoring or auditing cost in order to reveal the true project returns and receive full re-payment.
The size of the external finance premium that results from these market frictions may be affected by monetary policy actions. The credit channel—or, equivalently, changes in the external finance premium—can occur through two conduits: the balance sheet channel and the bank lending channel. The balance sheet channel refers to the notion that changes in interest rates affect borrowers' balance sheets and income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
s. The bank lending channel refers to the idea that changes in monetary policy may affect the supply of loans dispersed by depository institutions.
Balance sheet channel
The balance sheet channel theorizes that the size of the external finance premium should be inversely related to the borrower's net worth. For example, the greater the net worth of the borrower, the more likely she may be to use self-financing as a means to fund investment. Higher net worth agents may have more collateralCollateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
to put up against the funds they need to borrow, and thus are closer to being fully collateralized than low net worth agents. As a result, lenders assume less risk when lending to high net worth agents, and agency cost
Agency cost
An agency cost is an economic concept that relates to the cost incurred by an entity associated with problems such as divergent management-shareholder objectives and information asymmetry...
s are lower. The cost of raising external funds should therefore be lower for high net worth agents.
Since the quality of borrowers' financial positions affect the terms of their credit, changes in financial positions should result in changes to their investment and spending decisions. This idea is closely related to the financial accelerator
Financial accelerator
The financial accelerator in macroeconomics refers to the idea that adverse shocks to the economy may be amplified by worsening financial market conditions...
. A basic model of the financial accelerator suggests that a firm's spending on a variable input cannot exceed the sum of gross cash flows and net discounted value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of assets. This relationship is expressed as a "collateral-in-advance" constraint. An increase in interest rates will tighten this constraint when it is binding
Constraint (mathematics)
In mathematics, a constraint is a condition that a solution to an optimization problem must satisfy. There are two types of constraints: equality constraints and inequality constraints...
; the firm's ability to purchase inputs will be reduced. This can occur in two ways: directly, via increasing interest payments on outstanding debt or floating-rate debt, and decreasing the value of the firm's collateral through decreased asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
-prices typically associated with increased interest rates (reducing the net discounted value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of the firm's assets); and indirectly, by reducing the demand for a firm's products, which reduces the firm's revenue while its short-run fixed cost
Fixed cost
In economics, fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month, and are often referred to as overhead costs...
do not adjust (lowering the firm's gross cash flow). The reduction in revenue relative to costs erodes the firm's net worth and credit-worthiness over time.
The balance sheet channel can also manifest itself via consumer spending on durables
Durable good
In economics, a durable good or a hard good is a good that does not quickly wear out, or more specifically, one that yields utility over time rather than being completely consumed in one use. Items like bricks or jewellery could be considered perfectly durable goods, because they should...
and housing. These types of goods tend to be illiquid
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
in nature. If consumers need to sell off these assets to cover debts they may have to sell at a steep discount and incur losses. Consumers who hold more liquid financial assets such as cash, stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, or bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
can more easily cope with a negative shock
Shock (economics)
In economics a shock is an unexpected or unpredictable event that affects an economy, either positively or negatively. Technically, it refers to an unpredictable change in exogenous factors—that is, factors unexplained by economics—which may have an impact on endogenous economic variables.The...
to their income. Consumer balance sheets with large portions of financial assets may estimate their probability
Probability
Probability is ordinarily used to describe an attitude of mind towards some proposition of whose truth we arenot certain. The proposition of interest is usually of the form "Will a specific event occur?" The attitude of mind is of the form "How certain are we that the event will occur?" The...
of becoming financially distressed as low and are more willing to spend on durable goods and housing. Monetary policy changes that decrease the valuation of financial assets on consumers' balance sheets can result in lower spending on consumer durables and housing.
Bank lending channel
The bank lending channel theorizes that changes in monetary policy will shift the supply of intermediatedFinancial intermediary
Financial intermediation consists of “channeling funds between surplus and deficit agents”. A financial intermediary is a financial institution that connects surplus and deficit agents...
credit, especially credit extended through commercial banks. The bank lending channel is essentially the balance sheet channel as applied to the operations of lending institutions. Monetary policy actions may affect the supply of loanable funds
Bank reserves
Bank reserves are banks' holdings of deposits in accounts with their central bank , plus currency that is physically held in the bank's vault . The central banks of some nations set minimum reserve requirements...
available to banks (i.e. a bank's liabilities), and consequently the total amount of loans they can make (i.e. a bank's asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s). Banks serve to overcome informational problems in credit markets by acting as a screening agent for determining credit-worthiness. Thus many agents are dependent on banks to access credit markets. If the supply of loanable funds
Bank reserves
Bank reserves are banks' holdings of deposits in accounts with their central bank , plus currency that is physically held in the bank's vault . The central banks of some nations set minimum reserve requirements...
banks possess is affected by monetary policy changes, then so too should be the borrowers who are dependent on banks' funds for business operations. Firms reliant on bank credit may either be shut off from credit temporarily or incur additional search cost
Search cost
Search costs are one facet of transaction costs or switching costs. Rational consumers will continue to search for a better product or service until the marginal cost of searching exceeds the marginal benefit. Search theory is a branch of microeconomics that studies decisions of this type.The costs...
s to find a different avenue through which to obtain credit. This will increase the external finance premium, consequently reducing real economic activity.
The bank lending channel presumes that monetary policy changes will drain bank deposits so long as banks cannot easily replace the short-fall in deposits by issuing other uninsured liabilities. The abolition of reserve requirements on certificates of deposit in the mid-1980s made it much easier for banks facing falling retail deposits to issue new liabilities not backed by reserve requirements. This is not to say that the bank lending channel is no longer relevant. On the contrary, the fact that banks can raise funds through liabilities that pay market interest rates exposes banks to an external finance premium as well. Forms of uninsured lending carry some credit risk relative to insured deposits. The cost of raising uninsured funds will reflect that risk, and will be more expensive for banks to purchase.
Empirical evidence
The theory of a credit channel has been postulated as an explanation for a number of puzzling features of certain macroeconomic responses to monetary policy shocks, which the interest rate channel cannot fully explain. For example, Bernanke and Gertler (1995) describe 3 puzzles in the data:- The magnitude of changes in the real economy is large compared to the small changes in open-market interest rates due to monetary policy adjustments.
- Key components of spending do not respond to interest changes immediately. In fact, they respond only after the interest rate effect has past.
- Monetary policy adjustments that affect short-term interest ratesFederal funds rateIn the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
have large effects on variables that should respond to long-term interest rates (e.g. residential investmentInvestmentInvestment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
).
Since the credit channel operates as an amplification mechanism along side the interest rate effect, small monetary policy changes can have large effects if the credit channel theory holds. Asset price boom and bust patterns in the 1980s may have led to the subsequent real fluctuations observed in many advanced economies. It has also been found that small firms, who are credit constrained relative to larger firms, respond to cash flow squeezes by cutting production and employment. Large firms, by contrast, respond to cash flow squeezes by increasing their short-term borrowing. Moreover, this empirical result still holds when controlling for industry characteristics and financial criteria. Recent research at the Federal Reserve suggests that the bank lending channel manifests itself through the mortgage lending
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
market as well. Monetary policy tightening
Contractionary monetary policy
Contractionary monetary policy is monetary policy that seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry....
may force banks to shift from retail deposits
Deposit account
A deposit account is a current account, savings account, or other type of bank account, at a banking institution that allows money to be deposited and withdrawn by the account holder. These transactions are recorded on the bank's books, and the resulting balance is recorded as a liability for the...
insured by the Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...
to uninsured managed liabilities if they wish to continue financing mortgages. This will increase banks' external finance premium. Banks who lend heavily in sub-prime
Subprime lending
In finance, subprime lending means making loans to people who may have difficulty maintaining the repayment schedule...
communities will face higher external finance premiums because the risk from holding assets composed largely of subprime borrowers is relatively high. As a result, banks have to raise funds through instruments that offer higher interest payments. The empirical evidence suggests that banks that lend heavily in subprime communities and rely mostly on retail deposits reduce mortgage issuance relative to other banks in the face of a monetary contraction. No evidence was found of reductions in mortgage lending initiating from other banks who do not lend heavily in subprime communities or who do not rely heavily on retail deposits in response to monetary policy tightening.