Bank Lending, Collateral, and Credit Traps in a Monetary Union

This paper provides a theory to investigate the transmission of non-standard monetary policy to corporate lending in a monetary union where financial frictions limit firms’ access to external finance. The model incorporates a banking-sovereign nexus by assuming that sovereign default would generate a liquidity shock severely hitting domestic banks’ balance sheet. I find that this feature crucially impairs the transmission of monetary policy, generating asymmetric lending responses and the risk of contagion across economies. In particular I show that, in some circumstances, the liquidity injected into the risky country’s banks results in financing the sovereign rather than boosting lending, and sovereign risk in one country generates negative spillover effects on lending throughout the monetary union via the collateral channel. The model sheds light on the troubled transmission of the ECB’s policy measures to the economy of stressed countries during the euro sovereign debt crisis.