Does distance matter for financial stability and banking structures? This question is of high salience for all policy- efforts aiming to achieve coordination over large geographical areas as the European Banking Union. In this post, I provide an overview over the different concepts put forward in the economic literature.
Distance is a complex, multidimensional relational concept. In general, economic literature can be divided into two camps of looking at causation: While one group of economists suggest that distance has an exogenous shock nature in banking structure, others are arguing for its endogenous nature, as illustrated by two theories about the relation between distance and interest rates and the according impact of distance on the pricing and size of credit provision: while proponents of the information hypothesis predict interest rates to rise as distance increases as asymmetric information issues worsen (distance has an exogenous shock nature), the local market power view assumes interest rates fall with growing distance (for its endogenous nature), because banks enjoy less of a monopoly position.
Proponents of an endogenous view would, however, ask, how commercial banks make a decision for their location. They assume banks choose their structure themselves to maximise their income. Hence, if they don’t pay attention to the competition (banks located nearby) they lose income.
Cohen (1950) uses the term “monetary geography.” Most fundamentally, this refers to the spatial organization of currency relations, that is, how monetary domains are configured and governed. Whether we recognize it or not, we all carry around cognitive images of how currency spaces are organized; and these images – “mental” maps – in turn shape the way we intuitively think about the role of money in world affairs.
Regional analysis has usually overlooked references to financial and monetary variables. Leaving aside the widely held belief that money helps little to explain regional income differences, there are three main factors explaining this deficit.
- first, regional economists have usually assumed that money and monetary policy are neutral in the determination of real income, at least in the long run. The point here has usually been that if money does not really matter at national level, as orthodox monetary theory suggests, it should not matter at the regional level either.
- second, regions do not have monetary tools at their disposal. If one region does not really have the chance to run its own monetary policy, is there any point in studying the topic?
- third, if regions had their own monetary tools, their extreme openness and perfect capital mobility would leave them no possible control over their monetary conditions (money supply would be horizontal at some interest rate level and, therefore, endogenous). In fact, this is what the global monetarism theory foretells for small and open economies.
An important reason why monetary policy tends to be largely ignored in economic theories of development is because of the traditional postulate that money is neutral (at least in the long run). Thereby, monetary variables are only considered as a medium of exchange with no implications for long-run economic development. Nonetheless, money is not necessarily neutral because of the potential relevance of market failures, such as asymmetric information problems which will result in, inter alia, spatial segmentation of capital markets.
“Regional monetary policy” by Rodrıguez-Fuentes (1997) surveys and extends the research that has been done so far. His particular contribution is to build on the foundational work of Dow and Chick to explore how differences in regional banking systems affect the transmission of central monetary policy decisions to local economies. Dow and Chick, who are providing the preface to the book, rightly commend the analysis for being grounded in its application to regional economies, both within and among nations.
The core of the book highlights two ways in which there may be significant regional differences in banking systems.
The first is that a region’s banking system may be at a different stage of development than other regions in the monetary union. At an early stage of development, banks can be constrained by the quantity of reserve assets in the system, making the local supply of money more vulnerable to policy shocks.
Second, there may be regional differences in the liquidity preferences of financial actors (including the banks). Such differences can result in different lending behavior by regional banking systems in the face of tighter monetary policy implemented by the union’s central bank. These two considerations give rise to what Rodrıguez-Fuentes coins ‘the behavioral effect’ of monetary policy on regions, to be considered alongside or as an alternative to ‘the structural effect’ that has been the focus of much research in this field.
Many empirical studies have documented disparities in the regional responses to monetary policy shocks. Monetary policy affects some regions of the country more than others. A review of the large stance of empirical studies examining this issue reveals that this is due to the fact that some regions have a relatively high share of their economy in interest-sensitive industries, rendering them more susceptible to negative monetary policy shocks.
A conclusion we might draw from these studies is that a different mix of industries in regions is the only convincing explanation for regional asymmetric responses to monetary policy shocks. Ordinary monetary effects through a credit channel operating at the national level do not determine regional asymmetries.
Sergey is an economist at the Central Bank of Armenia and Visiting Lecturer at Yerevan Brusov State University of Languages and Social Sciences. His research analyses the link between economic geography and financial stability in the banking sector. He holds a PhD in economics (University of Economics Bratislava). This post does not necessarily represent the views of the Central Bank of Armenia.
Benjamin J. Cohen (1998). The Geography of Money. Cornell University Press.
Fuentes, C. J. R. (2005). Regional monetary policy. Routledge.
Michael Brei and Goetz von Peter (2017). The Distance Effect in Banking and Trade. Monetary and Economic Department. BIS Working Papers No 658.