Monetary Policy with a Touch of Basel

Abstract

The typical portrait of monetary policy has the banks and the money supply being manipulated through changes in bank reserves. However, with only a small portion of bank deposits now subject to reserve requirements, an alternative explanation of how monetary policy influences banks is needed. Over the last decade capital requirements have effectively replaced reserve requirements as the main constraint on the behavior of banks. This paper explores the implications of risk-based capital requirements, a la Basel, for monetary policy. In particular, we identify a "bank balance-sheet channel" of monetary policy, which operates through the impact of monetary policy on bank capital. We analyze the dynamics of the transmission mechanism and highlight its impact on the money stock and the economy, when banks are subject to capital requirements similar to those adopted under the Basel Accord.