Does Bank Capital Matter for Monetary Transmission? (Session 3: Financial Markets and Institutions)

By Van den Heuvel, Skander J. | Federal Reserve Bank of New York Economic Policy Review, May 2002 | Go to article overview

Does Bank Capital Matter for Monetary Transmission? (Session 3: Financial Markets and Institutions)


Van den Heuvel, Skander J., Federal Reserve Bank of New York Economic Policy Review


INTRODUCTION

Traditional monetary theory has largely ignored the role of bank equity. Bank-centered accounts of how monetary policy affects the real economy usually focus on the role of reserves and reserve requirements in determining the volume of demand deposits and, in the case of the bank lending channel, bank loans. As Friedman (1991) observed, "Traditionally, most economists have regarded the fact that banks hold capital as at best a macroeconomic irrelevance and at worst a pedagogical inconvenience." This stands in stark contrast to the importance attached to capital adequacy in the regulation of banks, especially since the adoption of the Basle Accord in 1988, which established risk-based capital requirements in the Group of Ten countries. The implementation of these regulations, along with other factors, has often been blamed for a perceived credit crunch in the United States immediately prior to and during the 1990-91 recession, giving rise to the term "capital crunch." (1) Research on this and other episodes has found that low bank capital is associated with sluggish lending. (2)

Despite this evidence, the role of bank capital and capital requirements in the monetary transmission mechanism has received much less attention. (3) This paper addresses this issue by examining how bank capital and its regulation affect the role of bank lending in the transmission of monetary policy. (4) I argue that taking into account bank capital has some interesting implications for our understanding of the monetary transmission mechanism. In addition, I briefly discuss whether recently adopted and proposed amendments to the Basle Accord can be expected to change these implications.

BANK CAPITAL AND THE LENDING CHANNEL

There are at least two theoretically distinct ways in which the level of bank capital can change the impact of monetary shocks on bank lending: through the traditional bank lending channel, also discussed in this volume by Lown and Morgan (2002), and through a more direct mechanism that can be described as a "bank capital channel." Both channels derive from a failure of the Modigliani-Miller theorem for banks. In a Modigliani-Miller world of perfect capital markets, a bank's lending decisions are independent of its financial structure. As the bank will always be able to find investors willing to finance any profitable lending opportunities, the level of bank capital is irrelevant to lending, and thus to the monetary transmission mechanism. (5) For each channel, this logic fails for a specific reason, although the nature of the failure is somewhat different in each case. Although the two are by no means mutually exclusive, it is easier to discuss them separately.

According to the bank lending channel thesis, monetary policy has a direct effect on the supply of bank loans, and thus on the real economy, because banks finance loans in part with liabilities that carry reserve requirements. (6) By lowering bank reserves, contractionary monetary policy reduces the extent to which banks can accept reservable deposits, if reserve requirements are binding. The decrease in reservable liabilities will in turn lead banks to reduce lending if they cannot easily switch to alternative forms of finance or liquidate assets other than loans. Thus, a necessary condition for a bank lending channel to be operative is that the market for nonreservable bank liabilities is not frictionless. (7) Otherwise, the bank could simply offset the decline in reservable deposits by costlessly switching to liabilities that carry no reserve requirements or lower reserve requirements, such as certificates of deposit (CDs), and there would be no reason for the bank to forgo profitable lending opportunities due to a binding reserve requirement.

Romer and Romer (1990), among others, claim that banks can in fact switch fairly easily to nonreservable liabilities, and for this reason they have expressed skepticism about the size of the lending channel.

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Does Bank Capital Matter for Monetary Transmission? (Session 3: Financial Markets and Institutions)
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