Cash

INTRODUCTION

Traditional monetary theory has largely ignored the role of bank equity. Bank-centered accounts of howmonetary policy affects the real economy usually focus on the role of reserves and reserve requirements in determining the volume of demand deposits and,in the case of the bank lending channel, bank loans. As Friedman (1991) observed, "Traditionally, mosteconomists have regarded the fact that banks hold capital as at best a macroeconomic irrelevance and at worst a pedagogical inconvenience." This stands in stark contrast to the importance attached to capital adequacy in the regulationof banks, especially since the adoption of the Basle Accord in 1988, which established risk-based capital requirements in theGroup of Ten countries. The implementation of these regulations, along with other factors, has often been blamed for a perceived credit crunch in the United States immediately prior to and during the 1990-91recession, giving rise to the term "capital crunch." (1) Research on this and other episodes has found that low bank capital is associatedwith sluggish lending. (2)

Despite this evidence, the role of bank capital and capital requirements in the monetary transmission mechanism has received much less attention. (3) Thispaper addresses this issue by examining how bank capital and its regulation affect therole of bank lending in the transmission of monetary policy. (4) I argue that taking into account bank capital has some interesting implications for our understanding of the monetary transmission mechanism. In addition, Ibriefly discuss whether recently adopted and proposed amendments to the Basle Accord canbe expected to change these implications.

BANK CAPITAL AND THE LENDING CHANNEL

There are at least two theoretically distinct ways in which the level of bank capital can change the impact of monetary shockson bank lending: through the traditional bank lending channel, also discussed in this volumeby Lown and Morgan (2002), and through a more direct mechanism that can be described as a "bank capital channel." Both channels derive from a failure of the Modigliani-Miller theorem for banks. In a Modigliani-Miller world of perfect capitalmarkets, a bank's lending decisions are independent ofits financial structure. As the bank will always be able to find investors willing to finance any profitable lending opportunities, the level of bank capital is irrelevant to lending, and thus tothe monetary transmission mechanism. (5) For each channel, this logic fails for a specific reason, although the nature of the failure is somewhat different ineach case. Although the two are by no means mutually exclusive, it is easier to discuss them separately.

Accordingto the bank lending channel thesis, monetary policy has a direct effect on the supply of bank loans, and thus on the real economy, because banks finance loans inpart with liabilities that carry reserve requirements. (6) By lowering bank reserves, contractionary monetary policy reduces the extent to which banks can accept reservable deposits, ifreserve requirements are binding. The decrease in reservable liabilities will in turn lead banks to reduce lending if they cannot easily switch to alternative forms of finance or liquidate assets other than loans. Thus, a necessary condition for a bank lending channel to be operative is that the market for nonreservable bank liabilities is not frictionless. (7) Otherwise,the bank could simply offset the decline in reservable deposits by costlessly switching to liabilities that carry no reserve requirements or lower reserve requirements, suchas certificates of deposit (CDs), and there would be no reason for the bank to forgo profitablelending opportunities due to a binding reserve requirement.

Romer and Romer (1990), among others, claim that banks can in fact switch fairly easily to nonreservable liabilities, and for this reasonthey have expressed skepticism about the size of the lending channel. Kashyap and Stein (1995, 2000) and Stein (1998), however, counter (and provide someevidence) that this type of Modigliani-Miller logic that Romer and Romer appeal to will fail ifthere is asymmetric information about the value of the bank's assets. In that case, as Stein's model shows, adverse selection leads to a "lemon's premium" inthe market for risky bank liabilities. Since most nonreservable bank liabilities are not insured, they are therefore at least somewhat risky, so the market for them is likely tobe imperfect.

This discussion of the lending channel makes no reference to bank capital or capital regulation. The reason for this is that, in essence, the lending channel occurs because banksface a liquidity constraint: if all banks always have sufficient cash or liquid securities, or can access a frictionless market for some managed liability, there is no lending channel. Nonetheless, there are some important connections between the strength of the lending channel and the level of bank capital.

First,as noted by Bernanke and Lown (1991) and Kashyap and Stein (1994), among others, the lending channel maybe less potent when bank equity is at or below the regulatory minimum for a sizable fraction of banks. This is because with a binding risk-based capitalrequirement, a bank cannot expand lending without additional capital. If it is costly to issue risky nonreservable liabilities--a prerequisite for the existence of the lending channel--then it is certainly costly to issue equity, the most junior liability. Inthe extreme case that equity is provided in any given period, shocks to reserves will have no effect on lending with a binding capital requirement. An increase in bank reserves will still lead to an increase in reservable bank liabilities in these circumstances, but theseadditional funds must be put in assets that do not carry a capital requirement, such as government securities. They cannot beused to make (private) loans. Thus, the lending channel is shut down. In the intermediate case in which the marginal cost of issuing equity is increasing inthe value issued (but not infinite), the lendingchannel will not be shut down completely, but it will be diminished in strength. Furthermore, as the discussion of the bank capital channel below makes clear,this effect may manifest itself even when the capital requirement is not currently binding, but may be binding in the future.

This suggests that monetarypolicy effects on bank lending will be smaller when more banks have low capital levels relative to the regulatory minimum. Unlike reserves, since there is nointerbank market for equity, it is therefore not just the average of bank capital that matters, but also its distribution across banks.

There is one important caveatto the conclusion that capital requirements, when binding, lower the effectiveness of monetary policy via the lending channel: the above effect is entirely static.If monetary policy actions affect bank profits, perhaps through changes in open market interest rates, then over time this will accumulate to changes in bank capital. Starting from a position of abinding capital requirement, any change in bank capital can in turn have a potentially large effect on lending. This dynamic effect is essentially the point ofthe bank capital channel, which I discuss in more detail below.

A second way in which bank equity can affect the strengthof the lending channel is by mitigating the adverse selection or moral hazard problems in the marketfor nonreservable bank liabilities. To see this, consider two banks with the same quality assets, but different liability structures--bank one, say, hasless equity and more debt than bank two. Suppose further that, following a contractionary monetary policy shock, both banks face an equal outflow of reservable deposits. (8) Thus, both banks need to issue managed liabilities, say, large-denomination CDs,to keep lending at a normal level. Even though both banks have equally risky assets, bank one's CDs are more risky because bank one has less equity to absorb future losses.Consequently, they are more exposed to any asymmetric information problems concerning the value of the bank's assets and thus command a larger lemon'spremium. Hence, following the contractionary monetary shock, bank one will optimally choose to issue fewer CDs and cut back lending by more than the better capitalizedbank two. We have now reached a seemingly opposite conclusion: the lending channel is stronger for banks withlower levels of capital.

It is important to note that for this second effect, it is arguably the market value ofbank equity that is the relevant quantity as the best measure of the bank's expected future free cash flows. For the first effect, which occurswhen capital requirements are binding, the right quantity is dearly the book value of bank capital, as defined by the capital regulations.