Information problems and deposit constraints at banks

Following the investment-cash flow literature, we test whether bank lending is constrained by the availability of insured deposits--a necessary condition for the existence of bank lending channel of monetary policy. We treat insured deposits as a type of "internal fund," similar to cash flows. We use a simple model to sort out the possible identification issues in interpreting a lending-deposit correlation, including reverse causality and omitted variable bias. To minimize the latter, we split the sample of banks by leverage and also use deposit flows at sister banks within a holding company as an "instrument." The results are consistent with the existence of frictions in capital market facing banks, and that such frictions force bank lending to be constrained by the availability of insured deposits. However, the frictions seem to matter only at small banks, suggesting that the bank lending channel of monetary policy is small. We also find evidence that bank holding companies mitigate these frictions by forming internal markets for allocating insured deposits among affiliated banks.