This paper confirms the importance of the financial systems behaviour conditions to the credit channel of monetary policy in the entire European Union (EU). It uses panel fixedeffect estimations and quarterly data for 26 EU countries for the period from Q1 1999 to Q3 2006 in an adaptation of the Bernanke and Blinder (1988) model. The findings also reveal the high degree of foreign dependence and indebtedness of the EU banking institutions and their similar reactions to the macroeconomic and the monetary policy environments.European integration; bank credit; monetary policy transmission; panel estimates.

Cândida Ferreira

English

Research Papers in Economics

 
 
 
  
 
 
 
Carlos Pestana Barros & Nicolas Peypoch  
 
 
A Comparative Analysis of Productivity Change in Italian and 
Portuguese Airports  
 
 
 
 
 
WP 006/2007/DE 
_________________________________________________________ 
 
 
 
Cândida Ferreira 
 
 
The Credit Channel Transmission of Monetary Policy in 
the European Union 
 
 
 
WP 08/2009/DE/UECE 
_________________________________________________________ 
Department of Economics 
WORKING PAPERS 
 
ISSN Nº 0874-4548 
School of Economics and Management 
TECHNICAL UNIVERSITY OF LISBON The Credit Channel Transmission of Monetary Policy in the European Union 
Cândida Ferreira
[1]  
 
 
Abstract 
This paper confirms the importance of the financial systems behaviour conditions to the 
credit channel of monetary policy in the entire European Union (EU). It uses panel fixed-
effect estimations and quarterly data for 26 EU countries for the period from Q1 1999 to Q3 
2006 in an adaptation of the Bernanke and Blinder (1988) model. The findings also reveal 
the high degree of foreign dependence and indebtedness of the EU banking institutions and 
their similar reactions to the macroeconomic and the monetary policy environments.  
 
JEL Classification: E4, E5, G2. 
Keywords: European integration; bank credit; monetary policy transmission; panel estimates. 
 
       
 
 
 
                                                      
[1] Instituto Superior de Economia e Gestão - Technical University of Lisbon 
(ISEG-UTL) and 
Unidade de Estudos sobre Complexidade e Economia (UECE) 
Rua Miguel Lupi, 20, 1249-078 - LISBOA, PORTUGAL 
tel: +351 21 392 58 00 
fax: +351 21 397 41 53 
(candidaf@iseg.utl.pt) 
   2
 
The Credit Channel Transmission of Monetary Policy in the European Union 
1. Introduction and Motivation  
In a recent survey of the most important topics and academic literature on the development 
of European banking, Goddart et al. (2007) stress the importance of the credit channel 
transmission of monetary policy in a world in which monetary policy becomes the most 
important instrument of stabilisation.  
This is particularly true in the European Union (EU), where the process of financial 
integration has implications for competition in the credit market and the banking institutions 
may have an important role in the transmission channels of monetary policy. 
Recently, several empirical papers have tested the importance of the bank lending channel 
for the transmission of monetary policies. With regard to Europe, most of them considered 
only the universe of the Economic and Monetary Union (EMU) and obtained rather similar 
conclusions on the relative homogeneity of the behaviour of the EU banking institutions and 
the importance of the banks’ liquidity, but not of their size or capitalisation to explain the 
adjustment of the credit lending to the interest rate variations (Erhmann et al., 2001; Fountas 
and Papagapitos, 2001; Altunbas et al., 2002; Gambacorta, 2004). Other contributions 
analyse the financial institutions’ role in different subsets of EU countries, some of them 
considering the new member-states (Golinelli and Rovelli, 2005; Elbourne and de Haan, 
2006; Ferreira, 2008).  
Few studies consider the universe of all EU countries, taking account of the fact that the 
introduction of the single currency has accelerated the process of consolidation and financial 
integration, not only in the EMU, but in the EU as a whole, in which the new member-states 
also have a voice, despite the possibly heterogeneous nature of their financial systems.   3
Using quarterly data for the period from Q1 1999 to Q3 2006 (31 quarters) for 26 EU 
countries and a version of the Bernanke and Blinder (1988), model, this paper seeks to 
contribute to the empirical study of the credit channel of monetary policy in the entire EU, 
under the new conditions arising from Europe’s financial integration. It tests the importance 
of some bank performance conditions to the bank lending channel transmission of monetary 
policy and develops the following vectors of analysis: 
1)  the possible similarities in the behaviour of the banking institutions in the different EU 
countries; 
2)  the importance of macroeconomic growth and the variation of the monetary policy 
interest rate to the growth of bank lending;  
3)  the influence on bank-lending growth of the bank performance conditions,  here 
represented by three specific ratios: bank deposits to GDP, bonds and money market 
instruments to GDP and foreign assets to foreign liabilities.  
 
The letter is organised as follows: Section 2 presents the estimated model and the data used; 
Section 3 reports the panel estimations and the obtained results and Section 4 presents the 
concluding remarks. 
 
 
2. The Model and the Data 
We estimate a version of the Bernanke and Blinder (1988) model. Basically, in the money 
market, we will assume that money equals deposits held at banks by the non-monetary 
sectors. So, for the demand function (Dep
d), we assume that the nominal deposits held in 
banks by the private sector will depend on the GDP and the interest rate on bonds (ibonds):  
( ) 1                                                             i    GDP    Dep   bonds 2 1 0
d α α α + + =  4
 
Money or deposits supply (Dep
s) will depend not only on the interest rate on bonds (ibonds), 
but also on the influence of monetary policy (represented here by the relevant monetary 
policy interest rate, imon.pol., which is defined by the Central Bank): 
 
In the credit market, the demand for lending (Lend
d) depends on the GDP, the interest rate 
on lending/borrowing (ilend) and the interest rate on bonds (ibonds): 
 
Assuming the relevance of one or more bank-performance characteristics (Charx) to lending, 
we may define the supply in the credit market (Lend
s) as depending on the deposits of the 
private sector in banks (Dep), as well as on the bank characteristics, the interest rate on 
lending/borrowing (ilend) and the interest rate on bonds (ibonds): 
 
Clearing the money and credit markets leads to the reduced form of the model and to the 
equation that will explain the bank-lending growth: 
 
where: 
Lend = bank lending 
GDP = Gross Domestic Product 
imon.pol. = monetary policy interest rate  
Carx = bank characteristics (x = 1,..X) 
 
( )       2                                                                     i   i   Dep mon.pol. 2 bonds 1 0
s β β β + + =
( ) 3                                                  i       i       GDP         Lend bonds 3 lend 2 1 0
d χ χ χ χ + + + =
( ) 4                                             i       i       Car       Dep         Lend bonds 4 lend 3 x 2x 1 0
s δ δ δ δ δ + + + + =
( )                     5                                          Car   i   GDP   Lend x 3x mon.pol 2 1 0 ϕ ϕ ϕ ϕ + + + =  5
So, the dependent variable will be the natural logarithm of the ratio of the domestic credit 
provided by the banking institutions to GDP. In order to explain the growth of this bank 
lending, we will consider (always in natural logarithms):  
•  The real GDP, representing the macroeconomic conditions of the different EU countries; 
•  The discount rate (end of the period), which is the monetary policy interest rate;   
•  The ratio deposits to GDP, that is, the total deposits in the banking institutions which are 
important sources of resources for credit lending; 
•  The ratio bonds and money market instruments to GDP, as a proxy of the development of 
the financial markets in EU countries, which are mostly bank-dominated; 
•  The ratio foreign assets to foreign liabilities, representing the financial situation of the 
banking institutions towards other countries, as they may receive payments from foreign 
debtors. The influence of this ratio on bank lending will reveal not only the openness of the 
financial markets, but mainly the degree of dependence on the other countries’ financial 
resources.  
 
To build our panel, we use Eurostat and International Financial Statistics (IFS) quarterly data 
for the period from Q1 1999 to Q3 2006 (31 quarters) for 26 EU countries, amounting to 806 
observations. Luxembourg has been excluded, as it was not possible to collect all the 
necessary data for this country.   
 
 
3. Estimations and Results 
Following Wooldridge (2002), we use a panel data approach which provides our estimations 
with more observations and reduces the possibility of multi-colinearity among the different 
variables. In order to control for individual country-specific effects, we use panel regressions   6
with fixed effects, which assume common slopes, whilst each cross section unit (here, each 
country), has its own intercept. So, we estimate the following linear model (all variables in 
natural logarithms): 
 
(Bank Lending/GDP)it =  ϕ1 real GDP per cap.it + ϕ2 Interest rate it + ϕ3 (Deposits/GDP) 
it +  ϕ4  (Bonds and Money Market Instruments/GDP)it + ϕ5 (Foreign Assets/Foreign 
Liabilities)it + νt + uit  
 
where: 
i = 1,..., 26 (EU countries) 
t = 1,..., 31 (quarters, between Q1 1999 and Q3 2006) 
νt = time (quarter) dummies 
uit = error term 
  
(Table 1 around here) 
 
The consistency of the obtained results (reported in Table 1) allows us to conclude that the 
EU banking institutions have similar reactions to the variations in the macroeconomic 
conditions, in particular to the monetary policy interest rate, as well as to the variations in the 
bank performance conditions.  
However, there remains evidence of heterogeneity and a clear difference in the obtained R 
squared values: they are similar (approximately 15%) both for the overall panel and for the 
between-countries hypothesis (testing the differences among the different countries), while 
the R squared within the countries, that is, when they are considered individually, rises to 
45%. This allows us to conclude that the time evolution in each country is more important 
than the cross-similarities among the countries in the same periods of time. 
Again, according to the results reported in Table 1, in all situations, only the ratio foreign 
assets to foreign liabilities has a negative influence on the bank lending growth, confirming   7
the importance of the foreign dependence and the indebtedness of the EU financial systems 
during this period. 
All the other explanatory variables contribute positively to bank-lending growth. In addition, 
the relatively strong influence of the ratio bonds and money market instruments to GDP 
confirms that the EU financial and credit systems continue to be bank-dominated, since the 
increase of the bonds and money market instruments are in line with the bank-lending 
growth. 
The positive contribution of the monetary policy interest rate to bank lending is not a 
surprise, in view of the fact that during the considered period, the European Central Bank in 
particular, as well as the central banks of the non-EMU member-states, maintained interest 
rates at historically low levels, thereby contributing to the growth of the ratio bank lending to 
GDP.  
 
 
4. Concluding remarks 
Following the proposed vectors of analysis and according to the obtained results, we 
conclude that, during the considered time period: 
1) In spite of the differing initial conditions, the EU financial institutions react in the same 
way and confirm the increased European financial integration; 
2) The bank-lending growth reacts positively to the particular macroeconomic conditions and 
increases not only with the growth in real GDP, but also with the historically low monetary 
policy interest rates;  
3) The bank performance conditions are particularly relevant to the growth of bank lending.  
   8
More precisely, we confirm the importance to bank lending of the bank deposits as a 
resource for the provision of credit, as well as the development of the European financial 
markets, here represented by the ratio bonds and money market instruments to GDP.  
On the other hand, the clear negative influence of the ratio foreign assets to foreign liabilities 
on bank-lending growth reveals the high degree of foreign dependence and indebtedness of 
the EU financial systems during this period.  
In sum, bank lending is an essential transmission channel of monetary policy decisions in EU 
countries, but it depends on the performance conditions of the different financial institutions. 
 
 
 
 
 
References: 
Altunbas, Y., O. Fazylow and Ph. Molyneux  (2002) "Evidence on the bank lending channel in 
Europe ," Journal of Banking and Finance, 26 (11),  pp. 2093-2110. 
Bernanke, B. and A. Blinder (1988) "Credit, Money and Aggregate Demand" American Economic 
Review, No 78 (2) pp. 435-439 
Elbourne, A. and J. de Hann (2006) Financial structure and monetary policy transmission in 
transition countries, Journal of Comparative Economics, 34 (1), pp. 1-23. 
Erhmann, M., L. Gambacorta,, J. Martinez-Pagés, P. Sevestre and A. Worms (2001) Financial 
Systems and the Role of Banks in Monetary Policy Transmission in the Euro Zone, ECB Working 
Paper Nº 105. 
Ferreira, C. (2008) “The Banking Sector, Economic Growth and European Integration”, Journal of 
Economic Studies, forthcoming. 
Fountas, S. and A. Papagapitos, (2001) “The monetary transmission mechanism: evidence and 
implications for European Monetary Union” Economics Letters, 70, pp. 397-404    9
Gambacorta, L. (2004) “Inside the bank lending channel” European Economic Review, 49 (7), pp.  
1737-1759.  
Goddart, J., Ph. Molyneaux, J.O.S. Wilson and M. Tavakoli (2007) “European Banking: An 
overview”, Journal of Banking and Finance, 31(7), pp.1911-1935. 
Golinelli, R. and R. Rovelli (2005) Monetary policy transmission, interest rate rules and inflation 
targeting in three transition countries, Journal of Banking and Finance, 29 (1), pp. 183-201.  
Wooldridge, J. (2002) Econometric Analysis of Cross Section and Panel Data, the MIT Press. 
 
 
 
 
 
 
 
 
 
 
Table 1 - Panel Fixed Effects Estimations 
        Estimated 
Coefficient 
Standard 
Error 
T - Statistic  P - Value 
Real GDP   .1787042          .0906129  1.97  0.049 
Interest rate  .1293654         .0318979     4.06  0.000 
Deposits/ 
GDP 
 
.1997731          
 
.0326271 
 
6.12 
 
0.000 
Bonds and 
Money Market 
Instruments/GDP 
 
.1391677          
 
.014301 
 
9.73 
 
0.000 
Foreign 
Assets/Foreign 
Liabilities 
 
-.1088265       
 
.0195928 
 
-5.55    
 
0.000 
 
N =  806 
R-squared: within= 0.4505; between=0.1423; overall=0.1554 
corr(u_i, Xb)  = -0.0545 
F(35,745) =     17.45; Prob > F  =    0.0000 
F test that all u_i=0:     F(25, 745) =   484.15             Prob > F = 0.0000 
 
Note: Time dummies are included in the estimation, but the results are not reported. 
 

Credit, Money and Aggregate Demand&quot;

Econometric Analysis of Cross Section and Panel Data,

European Banking: An overview”,

Evidence on the bank lending channel in Europe ,&quot;

Monetary policy transmission, interest rate rules and inflation targeting in three transition countries,

The Banking Sector, Economic Growth and European Integration”,

The monetary transmission mechanism: evidence and implications for European Monetary Union”

The Credit Channel Transmission of Monetary Policy in the European Union

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The Credit Channel Transmission of Monetary Policy in the European Union

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