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The unfolding subprime crisis and the challenges facing central banks in using monetary policy to resolve the possible credit crunch, highlight the importance of understanding the relationship between monetary policy and risk-based capital requirements. We explore the implications of risk-based capital requirements, à la Basel, for the conduct of monetary policy. A “bank balance-sheet channel” of monetary policy is identified, which operates through bank capital and influences the bank's loan decision. Using a dynamic banking model, we endogenize the capital decision and show that banks are likely to hold capital above the regulatory minimum to avoid being constrained. We derive the option value of holding capital, and show how this value is affected by monetary policy, level of economic activity, structure of the banking industry, and by changes in the level of regulatory capital.

The ongoing subprime crisis illustrates the interconnection between regulatory constraints and the effectiveness of monetary policy.1 The top 25 banks in the United States (Europe), which had 8.3% (8.1%) Tier 1 capital and 11.4% (11.6%) in the form of total capital in the third quarter of 2007 (right before the substantial losses due to subprime lending), had to raise more than $270 Billion of new capital to increase their ability to issue new loans.2 More recently the stress test of the 19 largest banks in the United States estimated that the banks would have to raise an additional $362.9 Billion over and above the 208.6 Billion in TARP funds to weather the adverse scenario developed by its Treasury Department.3 Thus the ability of the Federal Reserve and the ECB to stimulate the economies of countries affected by the subprime crisis was limited by the availability of required capital. A growing body of research has now documented the implications of the new risk-based capital requirements for the banks’ behavior, in particular for asset portfolio allocation and lending behavior.4 Over the last twenty years, the Basel Accord, originally developed for the G-10 countries, was gradually adopted by a large percentage of countries in the world.5 While some of the implications were clearly intended by the designers of the Basel Accord, there is now consensus on the unintended effects of the capital requirements on the banks’ behavior. A number of papers have pointed out that Basel type risk-based capital requirements may have contributed to the credit crunch of the early 1990s in the US and in other emerging economies, and induced banks to engage in what is now referred to as “regulatory capital arbitrage.”6 This has given rise to a debate on the optimal design of bank regulations and supervision measures that rely on capital as a sufficient statistic, but which recognize the incentive effects of risk-based capital requirements on bank behavior. With the push towards global harmonization of bank regulations and the increased reliance on capital adequacy ratios to control bank behavior, the question now becomes, what are the implications for the conduct of monetary policy? In this paper, we show that, under Basel-type capital requirements, monetary policy will influence a bank's capital and, as a result, its lending behavior. We develop a dynamic model in which risk neutral banks are assumed to maximize the present value of all future profits, subject to a total capital constraint in an imperfectly competitive banking industry. To mimic the Basel Accord the loans are restricted based on the amount of total capital determined in the previous quarter. This industry structure implies that the optimal net interest margin on loans is usually above the marginal resource cost of deposits and loans such that there usually are economic profits. We show that in anticipation of the possibility that the total capital constraint binds, and its negative impact on bank profits, the bank will choose an optimal level of total capital this quarter to minimize the possibility of the total capital constraint binding next quarter subject to a marginal cost of total capital. Thus, banks in this world find it optimal to hold capital above the regulatory level.7 Monetary policy, in this model, influences the bank's decision to extend credit, by affecting the option value of holding bank capital, and the bank's equity decision. For example, a tight monetary policy, which raises the federal funds rate, will induce the bank to raise its current and future deposit rate. In the presence of an imperfectly competitive loan market, the bank will also reduce the net interest rate margin between loan and deposit rates. Moreover, the persistent increase in the deposit rate will raise the marginal cost of funding, which all else being equal, reduces the supply of future loans and the probability that the capital constraint will bind during the next quarter. This reduces the option value of holding more capital. As a result, the bank will hold less equity this quarter, which further reduces the supply of loans issued next quarter. Thus, contractionary monetary policy, through the decline in the bank's total capital, leads to a decline in loans in the next quarter. By affecting the bank capital, monetary policy affects the capacity of banks to lend. This gives rise to a “bank capital financial accelerator” in our model, which is distinct from the well known financial accelerator discussed in the literature; the latter arises due to the impact of the monetary policy on the balance sheet of borrowers, and, consequently, on the demand for loans. Nevertheless, the two effects, one arising from the supply side of loans and the other from the demand side for loans, together amplify the impact of monetary policy on the economy. Capital regulations are shown to introduce asymmetries in the impact of monetary policy on the supply and cost of loans.8 For example, when the capital constraint binds and there is an easing of monetary policy, the resulting drop in the marginal cost of loans will not generate the desired increase in the quantity of loans or a drop in the loan rates. In fact, in this case, the lower marginal cost of lending only results in lower deposit rates and higher profits for the capital-constrained banks. On the other hand, a rise in the marginal cost of lending, due to a tightening of monetary policy, will generate the desired quantity and price effects. This asymmetry is also present in the impact of demand for loan shocks on the initial supply of loans. When the capital constraint is binding, a sudden rise in the demand for loans (perhaps generated by a booming economy) would only translate into higher loan rates, as banks are prevented from extending more loans due to the presence of the capital constraint. On the other hand, a sudden drop in the demand for loans will result in lower rates and a lower supply of loans. Finally, an important implication of our work suggests that Basel type capital requirements may actually induce greater price collusion among banks in a given market. Rotemberg and Saloner (1986) showed earlier that implicit collusion on price can breakdown resulting in a price war, when there is a significant increase in the demand for a firm's output. We show that in the case of an oligopolistic banking industry, the possibility of a price war is in fact reduced by the presence of regulatory capital requirements. These regulatory constraints limit a bank's ability to expand the supply of loans to benefit from an increase in the demand for loans. Thus, by reducing the expected profits from undercutting other banks, the new capital requirements may inadvertently favor collusive behavior at the expense of price competition. The rest of the paper is organized as follows: the next section provides a survey of the relevant literature. Section 3 establishes the relationship between the total capital constraint under the Basel Accord and the bank's balance sheet. Section 4 introduces the model of bank behavior under an oligopolistic industry structure. Section 5 analyses the impact of monetary policy under the Basel Accord. Section 6 concludes.

With the recent trend toward relying on risk-based capital as an instrument to control bank behavior, the question arises as to what, if any, are the implications for the conduct of monetary policy. This paper shows that monetary policy, in the presence of risk-based capital requirements, à la Basel, will affect the capacity of banks to supply loans when there is non-competitive behavior in the banking industry. The monetary policy works through the “bank balance-sheet channel” by impacting the value of a bank's capital, its profitability and the value of its stock. Thus, capital requirements can have a significant impact on the banking industry and on the economy as a whole. We show that holding capital endows the bank with a call option whose value is affected by the monetary policy, the level of economic activity, the structure of the banking industry, technological shocks to banking services, and by changes in the level of regulatory capital. Thus, we use a contingent-claim contract approach to highlight the impact of the aforementioned factors on the supply and pricing of loans, on the bank's profitability, and on the value of its capital. Capital requirements are shown to introduce asymmetries into the effects of these variables on the banking industry. Basel capital requirements also have an interesting and important impact on the banking industry. In economies where there is bank concentration and market power is present, capital requirements are shown to maintain, and perhaps enhance, collusive behavior among the banks. Capital requirements, when present, reduce the expected profits to cheating banks, and as a result, reduce the incentive for individual banks to renege on cooperative agreements. Market power in the banking industry has significant implications for the transmission of monetary policy. Thus, monetary policy impacts the value of holding capital through its effect on the bank's net interest margin. A reduction in the net interest margin, say, due to a tightening of monetary policy, will reduce the bank's profitability and the value of its capital. As a result, a bank is less likely to hold capital, which, in turn, will constrain the supply of loans in the future. Thus, we identify a “bank capital financial accelerator” which is distinct from the demand-driven financial accelerator. The latter arises due to the impact of monetary policy on the balance sheet and creditworthiness of borrowers. Interestingly, the presence of asymmetries in the impact of the monetary policy and the other factors, mentioned earlier, imply pro-cyclical impact on the banking industry and on the economy. How the two financial accelerator effects interact and their implications for the economy, as a whole, remains a topic for our future research. Finally, the three pillars approach of the new Basel Accord will not fundamentally change our results concerning the transmission of monetary policy.27 The new accord, which maintains the same definition of regulatory capital and the minimum eight percent capital adequacy as in Basel I, will continue to have explicit restrictions on the amount of lending albeit with a more complex market measure of risk adjusted assets. In addition, Kashyap and Stein (2004), Ayuso et al. (2004), and Barajas et al. (2004) point out that Basel II will make the capital requirement more burdensome during recessions since the probability of default on loans increases during these times. To the extent that the subprime crisis underscores the interconnection between monetary policy and regulatory policy, we argue that understanding how the bank capital channel of monetary operates, would go a long way to ensuring a better coordination between both policies.