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The Bank Capital Channel of Monetary Policy

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  • Skander Van den Heuvel

    () (Finance Department University of Pennsylvania)

Abstract

This paper examines the role of bank lending in the transmission of monetary policy in the presence of capital adequacy regulations. I develop a dynamic model of bank asset and liability management that incorporates risk-based capital requirements and an imperfect market for bank equity. These conditions imply a failure of the Modigliani-Miller theorem for the bank: its lending will depend on the bank’s financial structure, as well as on lending opportunities and market interest rates. Combined with a maturity mismatch on the bank’s balance sheet, this gives rise to a ‘bank capital channel’ by which monetary policy affects bank lending through its impact on bank equity capital. This mechanism does not rely on any particular role of bank reserves and thus falls outside the conventional ‘bank lending channel’. I analyze the dynamics of the new channel. An important result is that monetary policy effects on bank lending depend on the capital adequacy of the banking sector; lending by banks with low capital has a delayed and then amplified reaction to interest rate shocks, relative to well-capitalized banks. Other implications are that bank capital affects lending even when the regulatory constraint is not momentarily binding, and that shocks to bank profits, such as loan defaults, can have a persistent impact on lending

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File URL: http://repec.org/sed2006/up.31231.1139971981.pdf
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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 512.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:512

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Related research

Keywords: Monetary Policy; Bank Capital; Capital Requirements; Bank Lending Channel;

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  1. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937.
  2. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711.
  3. Mathias Dewatripont & Jean Tirole, 1994. "The prudential regulation of banks," ULB Institutional Repository 2013/9539, ULB -- Universite Libre de Bruxelles.
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