Academics and regulators have been debating for many years the mechanisms through which monetary policy interacts with credit market imperfections to influence firm investment, hiring, and ultimately output. One of these mechanisms is known as the ‘firm balance-sheet channel’, which refers to how the strength of the balance sheet of firms and their ability to access external finance is affected by monetary policy (Bernanke and Gertler 1995, Mishkin 1995). Bank lending represents an important component of firm borrowing, and most bank loans and credit lines offered to firms carry floating interest rates. It is important to understand the extent to which the ‘firm balance-sheet channel’ is the result of a pass-through of interest rates from monetary policy to the cost of outstanding debt of firms, a mechanism that has not been systematically studied before.
Floating-rate loans, reference rates, and hedging
Two observations have been largely overlooked in the literature on monetary economics:
- Monetary policy drives the reference rates underlying floating-rate loan arrangements (See Figure 1); and
- The vast majority of corporate loans from banks carry a floating rate.
These two facts suggest that monetary policy may affect the liquidity position of firms and their ability to finance future projects because it changes the cost of servicing existing bank loans.
Figure 1. The relation between the Federal Funds target rate and floating-rate debt reference rates
Source: Federal Reserve Bank of St. Louis FRED Economic Data.
In Ippolito et al. (2013), we document that 76% of the outstanding debt of US corporations that borrow solely from banks has a floating rate, compared with 9% of debt for those firms that have only non-bank debt (Figure 2).1 Because loans are mostly floating-rate, their presence in the balance sheet of a firm makes the firm’s stock price more sensitive to monetary policy. While a typical firm's stock price decreases by about 4% to 5% in response to a 1% surprise increase in the Federal Funds rate, the stock price of a firm that has one standard deviation more bank debt (relative to assets) drops by an additional 1.6%.2 These results indicate that firms with large amounts of bank debt are significantly more exposed to changes in interest rates.
Figure 2. The relation between bank debt and floating-rate debt
Source: Authors’ estimation
To disentangle the ‘floating-rate channel’ from other transmission mechanisms, it is useful to distinguish between firms that hedge their floating-rate debt exposure from those that do not. Despite their usage of bank loans, hedgers should be much less exposed to changes in interest rates than non-hedgers. This is indeed the case, as can be seen in Figure 3 below. The panels in Figure 3 display the average additional effect of a 1% surprise increase in the Federal Funds target rate on the cumulative stock price return of a hypothetical firm that is financed exclusively with bank debt, relative to a firm with no bank debt. In the bottom (top) panel the sample consists of firms that hedge (do not hedge) interest rate risk. Following a 1% surprise increase in the policy rate, the entire stock price decline due to the use of bank debt comes from the sample of unhedged firms, consistent with the floating-rate channel.
Figure 3. Cumulative reaction to 1% surprise monetary policy tightening associated with the use of bank debt: hedgers vs non-hedgers
Real effects of the exposure to floating-rate debt
The question remains whether firms with bank borrowing experience real effects that involve variables such as investment, cash holdings and sales because of their higher exposure to interest rate fluctuations. We examine this issue and show that following an increase in interest rates, the interest coverage ratio (measured as total cash flow over interest expenses) of firms with large exposure to unhedged bank loans drops significantly over the following six quarters. For the more financially constrained firms, the change in monetary policy translates into a liquidity shock that leads to a drop in cash holdings.
Bank debt usage is associated with a higher sensitivity of inventory, fixed investment, and sales to monetary policy changes for financially constrained firms that do not hedge. Six quarters after a 1% monetary policy tightening, financial constraints are associated with additional decreases in inventories and fixed investment of 22.1% and 15.8%, respectively, for a hypothetical firm fully financed by bank debt and unhedged, but these additional decreases are reduced to less than half when firms are hedged.
Taken together, this evidence suggests that the effect of the floating rate channel goes beyond a simple reallocation of cash flows between lenders and shareholders, and has significant real implications for the affected firms.
How does it compare to other channels
How does the floating rate channel compare to the traditional bank lending channel? The academic literature estimates that a 1% rate hike generates an average $0.3 cash shortfall on a $100 dollar business loan through the bank lending channel. In comparison, the floating rate channel generates a $0.32-$0.88 cash shortfall under the same scenario, suggesting that the floating-rate channel is at least as important as the traditional bank lending channel.
Zero lower bounds and the efficacy of unconventional monetary policy
During the recent zero lower bound period, the reference rates of floating rate loans were unresponsive to the unconventional monetary policy based on long-term asset purchases. Considering how important the floating-rate channel is, this suggests that during periods at the zero lower bound, the efficacy of unconventional monetary policy is potentially hindered. With unconventional methods, a relaxation of monetary policy does not necessarily translate into cheaper cost of debt for firms with outstanding bank loans. The lack of a pass-through effect during periods of unconventional monetary policy is potentially problematic. In these periods, monetary policy loses traction primarily with bank-dependent firms, which also tend to be more financially constrained.3
The widespread use of floating-rate loans means that there is a direct pass-through of interest rates from monetary policy to the cost of debt of corporations. This fact bears non-trivial implications for how changes in monetary policy affect firm behaviour in the cross-section. The floating-rate channel appears to be a key element of what is known as the firm balance-sheet channel. The floating-rate channel is distinct from other channels studied in the literature because it operates through the cost of existing debt rather than on new debt.
Our discussion of the floating rate channel also bears implications for the efficacy of unconventional monetary policy. The floating-rate channel does not operate with unconventional monetary policy, because large-scale asset purchases have little direct effect on the cost of finance for outstanding bank loans.
Bernanke, B S, and M Gertler (1995), “Inside the Black Box: The Credit Channel of Monetary Policy Transmission”, Journal of Economic Perspectives, 9, 27-48.
Evans, C, J D M Fisher, F Gourio, S Krane (2015), “Risk Management for Monetary Policy Near the Zero Lower Bound”, Working Paper
Gurkaynak, R S, B Sack, and E T Swanson (2005), “Do Actions Speak Louder than Words? The Response of Asset Prices to Monetary Policy Actions and Statements”, International Journal of Central Banking, 1, 55--93.
Kuttner, K N (2001), “Monetary Policy Surprises and Interest Rates: Evidence from the Fed Funds Futures Market”, Journal of Monetary Economics, 47, 523--544.
Faulkender, M (2005), “Hedging or Market Timing? Selecting the Interest Rate Exposure of Corporate Debt”, Journal of Finance, 60, 931--962.
Ippolito, F, A K Ozdagli, and A Perez-Orive (2013), “The Transmission of Monetary Policy through Bank Lending: The Floating Rate Channel”, CEPR Working Paper No. 9696
Mishkin, F S (1995), “Symposium on the Monetary Transmission Mechanisms”, The Journal of Economic Perspectives, 3-10.
Vickery, J (2008), “How and why do small firms manage interest rate risk?”, Journal of Financial Economics, 87(2), 446-470.
1 Faulkender (2005) finds that about 90% of syndicated bank loans to chemical corporations are issued at a floating rate. Vickery (2008) finds that about 70% of loans have a floating rate in the Federal Reserve's Survey of Terms of Business Lending.
2 These calculations are estimated using market-based surprise measures as in Kuttner (2001) and Gurkaynak et al. (2005).
3 This result could shed light on the debate about the costs and benefits of unconventional policy, a topic that has received increased attention recently (e.g. Evans et al. 2015).