Kiel Working Papers, Kiel Institute for World Economics
No 1569:
A Tale of Two Policies: Prudential Regulation and Monetary Policy with Fragile Banks
Ignazio Angeloni and Ester Faia
Abstract: We introduce banks, modeled as in Diamond and Rajan (JoF
2000 or JPE 2001), into a standard DSGE model and use this framework to
study the role of banks in the transmission of shocks, the effects of
monetary policy when banks are exposed to runs, and the interplay between
monetary policy and Basel-like capital ratios. In equilibrium, bank
leverage depends positively on the uncertainty of projects and on the
bank’s "relationship lender" skills, and negatively on short term interest
rates. A monetary restriction reduces leverage, while a productivity or
asset price boom increases it. Procyclical capital ratios are
destabilising; monetary policy can only partly offset this effect. The best
policy combination includes mildly anticyclical capital ratios and a
response of monetary policy to asset prices or leverage
Keywords: capital requirements, leverage, bank runs, combination policy, market liquidity; (follow links to similar papers)
46 pages, October 2009
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