Financial Dampening

We propose a novel mechanism, “financial dampening,” whereby loan retrenchment by banks attenuates the effectiveness of monetary policy. The theory unifies an endogenous supply of illiquid local loans and risk sharing among subsidiaries of bank holding companies (BHCs). We derive an instrumental variable (IV) strategy that separates supply‐driven loan retrenchment from local loan demand by exploiting linkages through BHC internal capital markets across spatially separate BHC member banks. We estimate that retrenching banks increase loan supply substantially less in response to exogenous monetary policy rate reductions. This relative decline has persistent effects on local employment and thus provides a rationale for slow recoveries from financial distress.