Monetary Policy Transmission and Non-Performing Loans

In this paper, we investigate the role that non-performing loans (NPLs) have to play in the pass-through of monetary policy to lending rates. We develop a theoretical framework which predicts that the transmission mechanism is... [ view full abstract ]

In this paper, we investigate the role that non-performing loans (NPLs) have to play in the pass-through of monetary policy to lending rates. We develop a theoretical framework which predicts that the transmission mechanism is weakened the greater the impairment of banks' balance sheets. We then test this implication by estimating a pass-through model on a dataset which links the NPL positions of individual euro area banks to a panel of their lending rates and other balance sheet items.

Our results show that greater impairment of bank balance sheets weakens the pass-through of monetary policy to lending rates. A 1 percentage point increase in the NPL ratio lowers the pass-through coefficient by 2.3 percentage points. Furthermore, we find that beyond a certain level of impairment, banks cease to pass through changes in money market rates in the short-run. However, we find that long-run pass-through is less affected by NPLs, suggesting that NPLs are not a long-run determinant of pass-through. We find that pass-through is affected by market competition and by other bank-specific characteristics, controlling for macroeconomic conditions.