Working Paper: CEPR ID: DP10200
Authors: Chuan Du; David Miles
Abstract: Banks? behaviour can be influenced by both monetary policy and regulatory capital requirements. This paper explores the interaction between these two policy tools in promoting better lending decisions by banks. We develop and calibrate a model of bank lending to examine what an optimal combination of monetary policy and regulatory capital requirements might look like. We find that as prudential standards strengthen globally in the aftermath of the financial crises, it is likely that the that equilibrium level of central bank policy rates should be lower than they had been prior to the crisis.
Keywords: capital requirements; macro prudential policy; monetary policy
JEL Codes: E52; E58; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Tightening monetary policy (E52) | Improves prudence among banks (G21) |
| Improves prudence among banks (G21) | More cautious lending behavior (G21) |
| Tightening monetary policy (E52) | Decreased participation in lending (G21) |
| Strengthening capital requirements (G28) | Decreased equilibrium level of central bank policy rates (E52) |
| Banks with low capital (G21) | More prone to excessive risk-taking (G41) |
| Limited liability (K13) | More prone to excessive risk-taking (G41) |
| Inability to credibly communicate success probabilities (D80) | More prone to excessive risk-taking (G41) |
| Excessive risks taken by undercapitalized banks (F65) | Undermines financial stability (F65) |
| Stronger capital requirements (G28) | Increased participation threshold (D72) |
| Increased participation threshold (D72) | Foregoing investment opportunities (G31) |