Monetary Policy and Anti‐cyclical Bank Capital Regulation

Abstract

The financial crisis of 2008–2009 revived attention given to booms and busts in bank credit, and their effects on real activity. This interest sparked two different strands of research in macro. The first one focuses on monetary policy in the context of financial frictions. The second studies capital regulation in banking. To the best of our knowledge, so far these two topics have mostly been studied in isolation from each other. Thus, we still lack an understanding of how monetary policy and bank capital regulation interact in the presence of financial fragility. This paper aims to contribute to furthering this understanding. Specifically, we ask how the monetary policy rule should look like in the presence of cyclical capital requirements. We extend the dynamic stochastic general equilibrium model with bank capital in Aliaga‐Díaz and Olivero by introducing price rigidities in the spirit of the New‐Keynesian literature. We find that: First, anti‐cyclical requirements have important stabilization properties relative to the case of constant requirements. This is true for all types of fluctuations that we study, which include those caused by productivity, preference, fiscal, monetary, and financial shocks. Second, output and consumption volatilities present in the no regulation economy can be recovered with anti‐cyclical requirements as long as the policy rate responds only slightly to credit spreads. Third, monetary policy rules that respond to credit conditions also perform better in terms of welfare. (JEL E32, E44)

Managing Risk Taking With Interest Rate Policy and Macroprudential Regulations

“…Benes and Kumhof (2015) show that countercyclical capital buffers are welfare improving in a model in which bank loans are risky because the lending rate is not state-contingent. Aliaga-Díaz et al (2018) show that countercyclical capital requirements have stabilization properties relative to constant requirements. However, when their model allows monetary policy to have an impact on risk taking, optimal capital regulation and monetary policy are both countercyclical.…”

“…Adrian and Boyarchenko (2018) study the interaction of capital and liquidity regulation in a dynamic general equilibrium model. Aliaga-Díaz et al (2018) show that countercyclical capital requirements have stabilization properties relative to constant requirements. Angelini et al [2014] show that countercyclical capital requirements reduce the volatility of macro aggregates.…”