In an influential paper, Bernanke and Gertler (1995) point out that the credit channel for monetary transmission works through the supply side, and amplifies the more traditional "money channel." When a central bank tightens monetary policy by squeezing reserves, it generates a corresponding reduction in the supply of bank loans. But this results in a real contraction only if banks cannot costlessly change the composition of their liabilities by issuing certificates of deposits or bonds, and firms cannot shift to bonds and commercial papers. The money channel emphasizes the impact of monetary tightening on balance sheets and on asset prices, and consequently the market value of wealth.
Kashyap and Stein (1994) show that, as with firms, banks cannot seamlessly generate loanable funds when tighter monetary policy restricts their ability to generate loans from deposits. The alternative avenues for banks to raise funds include large-denomination certificates of deposit, medium-term notes, and other securities that are not subject to regulatory restrictions. The authors point out, however, that these securities are not subject to deposit insurance and similar arrangements, and can only be issued at higher costs and to investors with different risk appetites. Because of capital market imperfections, shocks to the deposit base cannot be frictionlessly offset with other sources of financing, and they, therefore, translate into real effects on lending behavior.
Disyatat (2010) questions the link between bank deposits and the money multiplier (credit channel), suggesting that the ability or willingness of banks to provide credit is influenced more by bank capital and the risk to bank balance sheets. The bank lending channel can also be reinforced by the impact of monetary policy on perceptions of risk and willingness to bear risk. The case for these links has been put forward by Bernanke and Gertler (1995) and Borio and Zhu (2008). The latter call this mechanism the "risk-taking channel."1 One avenue through which these effects may work is the impact of interest rates on financial buffers or the perceived vulnerability of agents to future economic shocks. For example, policy tightening may raise perceptions that firms are at risk because of increasing tensions on cash flows and weakening balance sheets. Expectations of slower economic activity may raise the risk of bankruptcy. As emphasized earlier, the procyclical behavior of estimates of default probabilities and loss in the event of a default can also be a manifestation of the influence of risk perceptions that is driven in part by monetary policy. The level of interest rates may also influence riskier behavior: when interest rates are low, the search for yield leads to increased investments in riskier assets, as downside risks are downplayed.
The role of monetary policy in response to inflation also affects project financials and bank lending. The impact of inflation, as analyzed by Visconti (2012), occurs through the relative impact on the weighted average cost of capital and the net present value. Given this, inflation unambiguously increases the denominator in the net present value equation and so reduces the net present value. Inflation also increases the cost of debt (as bank debt is floating and indexed to inflation) and, therefore, increases the weighted average cost of capital. Thus, a very real scenario presents itself: with higher inflation, the weighted average cost of capital may exceed net present value, and could result in equity as well as cash burnout.