Capital regulation, risk-taking and monetary policy: A missing link in the transmission mechanism?

Few areas of monetary economics have been studied as extensively as the transmission mechanism. The literature on this topic has evolved substantially over the years, following the waxing and waning of conceptual frameworks and the changing characteristics of the financial system. In this paper, taking as a starting point a brief overview of the extant work on the interaction between capital regulation, the business cycle and the transmission mechanism, we offer some broader reflections on the characteristics of the transmission mechanism in light of the evolution of the financial system. We argue that insufficient attention has so far been paid to the link between monetary policy and the perception and pricing of risk by economic agents—what might be termed the “risk-taking channel” of monetary policy. We develop the concept, compare it with current views of the transmission mechanism, explore its mutually reinforcing link with “liquidity” and analyse its interaction with monetary policy reaction functions. We argue that changes in the financial system and prudential regulation may have increased the importance of the risk-taking channel and that prevailing macroeconomic paradigms and associated models are not well suited to capturing it, thereby also reducing their effectiveness as guides to monetary policy.

► We propose a risk-taking channel of monetary policy, which highlights the link between monetary policy and the perception and pricing of risk by economic agents. ► There is often reinforcing links between risk-taking and liquidity. ► Changes in the financial system and prudential regulation may have increased the importance of the risk-taking channel. ► Prevailing macroeconomic paradigms and associated models are not well suited to capturing the risk-taking channel, thereby reducing their effectiveness as guides to monetary policy.