Lianfa Li: Prudential Banking Regulation and Monetary Policy (Ohio State University, 2004)
Abstract
Central bankers know that financial intermediation is important for achieving macroeconomic stability. Without a functioning banking system, an economy will grind to a halt. But monetary policy and prudential supervisory policy can work at cross-purposes. While monetary policymakers want to ensure that there is always sufficient lending activity to maintain high and stable economic growth, bank supervisors work to limit banks' lending capacities in order to prevent excessive risk-taking. To avoid working at cross-purposes, central bankers need to adopt a policy strategy that accounts for the impact of capital adequacy requirements. For this purpose, I derive an optimal monetary policy (in chapter 2) that reinforces prudential capital requirements and stabilizes aggregate economic activities at the same time. In chapter 2, I also find empirical evidence that in the United States the Federal Reserve lowers interest rates by more when the bank capital constraint binds during downturns, which is consistent with the theory. In contrast, central bankers in Germany and Japan clearly do not adjust interest rate policy in a way that would neutralize the procyclical impact of bank capital requirements. On the other hand, it is the job of bank regulators and supervisors to ensure that the financial system functions smoothly. Despite the consensus that moral hazard is a main cause for significant banking sector problems, policymakers can not reach an agreement on how to design optimal prudential banking policies. In particular, little is known about how existing banking policies, such as capital adequacy requirements and deposit insurance, complement one another. By constructing a dynamic model of moral hazard with endogenous franchise values in chapter 3, I not only argue that a coordinated combination of optimal bank capital requirements and optimal deposit insurance can control moral hazard efficiently but also derive analytically the forms of optimal banking policies. In this model, more competition stimulates risk-taking by banks but risk-taking decreases when capital regulation and deposit insurance are conducted. Based on the bank data from 43 countries during the 1990s, I find evidence that both deposit insurance and capital adequacy requirements enhance banking stability.
Abstract
Central bankers know that financial intermediation is important for achieving macroeconomic stability. Without a functioning banking system, an economy will grind to a halt. But monetary policy and prudential supervisory policy can work at cross-purposes. While monetary policymakers want to ensure that there is always sufficient lending activity to maintain high and stable economic growth, bank supervisors work to limit banks' lending capacities in order to prevent excessive risk-taking. To avoid working at cross-purposes, central bankers need to adopt a policy strategy that accounts for the impact of capital adequacy requirements. For this purpose, I derive an optimal monetary policy (in chapter 2) that reinforces prudential capital requirements and stabilizes aggregate economic activities at the same time. In chapter 2, I also find empirical evidence that in the United States the Federal Reserve lowers interest rates by more when the bank capital constraint binds during downturns, which is consistent with the theory. In contrast, central bankers in Germany and Japan clearly do not adjust interest rate policy in a way that would neutralize the procyclical impact of bank capital requirements. On the other hand, it is the job of bank regulators and supervisors to ensure that the financial system functions smoothly. Despite the consensus that moral hazard is a main cause for significant banking sector problems, policymakers can not reach an agreement on how to design optimal prudential banking policies. In particular, little is known about how existing banking policies, such as capital adequacy requirements and deposit insurance, complement one another. By constructing a dynamic model of moral hazard with endogenous franchise values in chapter 3, I not only argue that a coordinated combination of optimal bank capital requirements and optimal deposit insurance can control moral hazard efficiently but also derive analytically the forms of optimal banking policies. In this model, more competition stimulates risk-taking by banks but risk-taking decreases when capital regulation and deposit insurance are conducted. Based on the bank data from 43 countries during the 1990s, I find evidence that both deposit insurance and capital adequacy requirements enhance banking stability.