Academic journal article Economic Inquiry

Do Capital Adequacy Requirements Matter for Monetary Policy?

Academic journal article Economic Inquiry

Do Capital Adequacy Requirements Matter for Monetary Policy?

Article excerpt

I. INTRODUCTION

Central bankers know that financial intermediation is important for achieving macroeconomic stability. Without a functioning banking system, an economy will grind to a halt. It is the job of regulators and supervisors to ensure that the financial system functions smoothly. But monetary policy and prudential supervisory policy can work at cross-purposes. An economic slowdown can cause deterioration in the balance sheets of financial institutions. Seeing the decline in the value of assets, supervisors will insist that banks should follow the regulation and ensure that they have sufficient capital given their risk exposures. The limit on bank lending set by capital adequacy requirements declines during recessions and increases during booms. And as intermediation falls, the level of economic activity goes down with it. It looks as if regulation deepens recessions. As the Basel Committee on Banking Supervision (2001) put, the capital regulation "has the potential to amplify business cycles."

Blum and Hellwig (1995) provided the first theoretical demonstration that capital requirements can exacerbate business cycle fluctuations. In focusing entirely on the behavior of the banking system, the Blum and Hellwig model provides an important first step, but in the end, their analysis is incomplete. They do not consider the response of the central bank to economic fluctuations. This assumption is critical for their result but certainly unrealistic. What if central banks conduct monetary policy to explicitly account for the impact of capital requirements? (1) Will the procyclical effect of capital requirements remain? Is this the optimal thing to do for central banks? To answer these questions, we derive an optimal monetary policy rule in both a static and a dynamic model where the potential procyclicality of capital requirements is embedded.

Our conclusions are as follows: a country's monetary policymakers should react to the state of their banking system's balance sheet. And when they do, the procyclical effect of prudential capital regulation can be counteracted and completely neutralized. For a given level of economic activity and inflation, the optimal policy reaction dictates setting interest rates lower, the more financial stress there is in the banking system when the economic activity is in the downturn. We present simulation results to give a sense of the magnitude of the required reaction. But when taking this proposition to the data and estimating forward-looking monetary policy reaction functions for the United States, Germany (preunification), and Japan, we find that while monetary policymakers in the United States behave as the theory suggests, lowering interest rates by more in downturns in which the banking system is under stress, by contrast, central bankers in Germany and Japan do not.

We derive optimal interest rate rules with the static model and the dynamic model in Sections II and III, respectively. Section IV reports the simulation results, and Section V discusses the empirical estimation. Section VI concludes.

II. A STATIC MODEL A. The Model

We begin with a static aggregate demand-aggregate supply model modified to include a banking sector. The purpose of this simple model is to highlight the impact of introducing bank capital requirements in their most stripped-down form in order to show the extent to which the banking industry can affect business cycles. The static model also sheds lights on the fruitful approach that solves the dynamic model.

The starting point is an aggregate demand curve that admits the possibility of banks having an impact on the level of economic activity. Following Bernanke and Blinder (1988), we distinguish between policy-controlled interest rate and lending rates and write aggregate demand as:

(1) [y.sup.d] = [y.sup.d](i - [[pi].sup.e], [rho] - [[phi].sup.e], [phi]) + [eta],

where i is the short-term nominal interest rate, [rho] is the nominal loan rate, [[pi]. …

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