Euro Area Banking and Monetary Policy Shocks in the QE Era: A Structural Credit Risk and Vector-autoregression Approach

This paper assesses the effects of monetary policy shocks on the macroeconomy and the euro area banking sector after the global financial crisis. Financial risk-return indicators of the banking sector based on a compound option-based structural credit risk model are embedded in a large macro-financial quarterly database covering the period 2008Q4-2019Q4. A SFAVAR identifies and estimates the shocks’ responses relating them to the endogenous build-up of banks’ vulnerabilities. The study finds that unconventional monetary policy, in particular the Asset Purchase Program of the European Central Bank, seems to have been more successful than conventional monetary policy in raising output and inflation. The desired boost to bank lending has been muted and loan cyclicality has varied across countries and loan types. The performance of the banking sector following monetary policy shocks can be characterized by a drop in expected ROE and ROA, a relaxation of lending conditions and increased correlation between banks’ assets return and the market return, a mechanism pointing to enhanced risk-taking. While banks’ probabilities of default fall following monetary policy shocks, financial leverage and the price of risk increase. Banks’ net worth rises via higher market capitalization and implied assets value together with lower volatility, albeit often incurring more debt. Risk-taking in the banking sector, such as the one observed in the run-up to the global financial crisis, may pose a risk to financial stability, especially if its effects on banks’ vulnerability spread to systemic risk. The endogenous build-up of macro-financial vulnerabilities may need to become part of monetary policymaking.