By David Aikman and Gertjan Vlieghe of the Bank's Monetary Assessment and Strategy Division.
In this article we consider how the composition of banks' balance sheets between capital and deposits affects the transmission of economic shocks. We use a small, stylised model of the economy to analyse under which conditions firms are unable to borrow as much as they would like from banks, and banks are unable to attract as many deposits as they would like from households. We show that, following shocks to aggregate productivity and bank net worth, the response of output in this model economy with credit constraints is both larger and longer-lasting than in a similar economy where credit constraints do not bind. This is because an adverse shock lowers bank capital, which constrains lending to firms and amplifies the fall in output; and it takes time for banks to rebuild their capital so it takes time for output to return to its initial level. We find that, in our model, only a small proportion of the fluctuations of output in response to productivity shocks is due to the bank capital channel, but this channel is more important when there are direct shocks to bank capital.