Monetary Transmission and Asset-Liability Management by Financial Institutions in Transitional Economies - Implications for Czech Monetary Policy

The paper deals with the transmission of monetary policy within the financial sector. The objective is to link an optimizing stochastic model of portfolio decisions by a representative financial institution with a number of features that this optimizing behavior implies for monetary transmission and credit conditions in a transitional economy. The main example is the intermediation performance of Czech financial sector in the years 1993 to 1999. In the theoretical part, I introduce a discrete time model of portfolio optimizing under uncertainty extended to cover the case of cash flow constraints imposed on a financial intermediary. The current utility is liquidity-dependent. It also depends on a variable that measures the momentary assessment of future cash flows generated by the current items in the balance sheet. This specification has consequences for asset valuation, the term structure of interest rates and the uncovered return parity property of the expected exchange rate. In particular, monetary policy impulses receive different responses than in standard optimizing models, which are reflected either by the term structure of interest rates or by interest rates on new credit. In the empirical part, I analyze a number of observations about the function of the Czech financial intermediation during transition and identify those that are relevant for the transmission mechanism. I undertake some simple comparisons of the effects predicted by the model with the available Czech data. Where possible, I also provide a projection of the models inferences for the Austrian banking sector. The proposed model provides two main lessons for the monetary authorities in transitional economies. First, the credit channel, whose specific evaluation measure is proposed, cannot be ignored. Second, in the pursuit of conventional inflation and quantity-of-money goals, the central bank must tune its key rate decisions to the asset-liability management objectives of the financial sector and the current dynamics of the term structure of interest rates.