Monetary policy with a touch of Basel

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.