Alternative Specifications of Bank Lending in France and Germany: Theory, Evidence and Policy Implications

In this paper I compare a capital budgeting model of of bank lending based on stock valuations to a supply/demand model based on an interest rate channel for France and Germany using non-nested hypothesis tests and omitted variables tests. For France both tests indicate a strong rejection of the supply/demand model with an interest rate channel and non-rejection of the capital budgeting model with a stock market channel. The results for Germany are mixed. For Monetary Financial Institutions the non-nested hypothesis tests rejected both models. For the commercial banking sector of Monetary Financial Institutions both tests rejected the supply/demand model but did not reject the capital budgeting model. Do these results have any implications for policy? If volatility in share prices cause volitility in bank lending which in turn causes volitility in real economic activity, then government may want to begin thinking about ways to dampen the volatility in the stock market such as imposing more stringent margin requirements on stock purchases and open market operations by central banks in a broad index of equity shares. I then consider the feasibility of Central Banks buying and selling a diversified portfolio of equites.