Bank Coordination and Monetary Transmission: Evidence from India

We propose a new channel for the transmission of monetary policy shocks, the coordination channel. We develop a New Keynesian model in which bank lending is strategically complementary. Banks do not observe the distribution of loans but infer it using Gaussian signals. Under this paradigm, expectations of tighter credit conditions reduce banks’ lending response to monetary shocks. As a result, lack of coordination and information about other banks’ actions dampen monetary transmission. We test these predictions by constructing a dataset that links the evolution of interest rates to firms’ bank credit relationships in India. Consistent with our model, we find that the cross-sectional mean and dispersion of lending rates, which capture the expected value and the precision of the signals of credit extended by other banks, are significant predictors of monetary transmission. Our quantitative results suggest that lending complementarities reduce monetary transmission to inflation and output by about a third.