The Bank Capital Channel of Monetary Policy Skander J. Van den Heuvel*Department of Finance The Wharton School University of Pennsylvania This version: June 2007 Abstract This paper examines the role of bank lending in the transmission of monetary policy in the presence of capital adequacy regulations. I develop a dynamic model of bank asset and liability management that incorporates risk-based capital requirements and an imperfect market for bank equity. These conditions imply a failure of the Modigliani-Miller theorem for the bank: its lending will depend on the banks financial structure, as well as on lending opportunities and market interest rates. Combined with a maturity mismatch on the banks balance sheet, this gives rise to a bank capital channel by which monetary policy affects bank lending through its impact on bank equity capital. This mechanism does not rely on any particular role of bank reserves and thus falls outside the conventional bank lending channel. I analyze the dynamics of the new channel. An important result is that monetary policy effects on bank lending depend on the capital adequacy of the banking sector; lending by banks with low capital has a delayed and then amplified reaction to interest rate shocks, relative to well-capitalized banks. Other implications are that bank capital affects lending even when the regulatory constraint is not momentarily binding, and that shocks to bank profits, such as loan defaults, can have a persistent impact on lending. (JEL Classification numbers: E440, E520, G280) *Email: vdheuvelwharton.upenn.edu. I would like to thank Christopher Sims, William Brainard and Stefan Krieger for valuable advice and comments. I would also like to thank Andrew Abel, Ben Bernanke, Patrick Bolton, Giancarlo Corsetti, Gaston Gelos, Joao Gomes, George Hall, Michael Krause, Stephen Morris, Nagpurnanand Prabhala, Jeremy Stein, Eric Swanson, and numerous seminar participants for valuable comments. Traditional monetary theory has largely ignored the role of bank equity. Bank-centered accounts of how monetary policy affects the real economy usually focus on the role of reserves in determining the volume of demand deposits. In addition, the bank lending channel thesis maintains that monetary policy actions can also alter the supply of bank loans by changing bank reserves. While reserve requirements play a central role in these theories, bank capital1and capital regulations are at best discussed as an afterthought. This paper constitutes an attempt to fill this gap by taking the risk-based capital requirements of the Basle Accord explicitly into account. It provides a framework for analyzing the consequences of these regulations for bank lending and the response of lending to monetary policy actions in a dynamic setting. The incorporation of bank capital effects is motivated by two sets of considerations. First, it is generally agreed that bank capital is an important factor in bank asset and liability management and that its importance has likely increased since the implementation of the risk-based capital requirements of the 1988 Basle Accord. The implementation of these regulations, along with other factors, has often been blamed for a perceived credit crunch immediately prior and during the 1990-91 recession. In fact, the term capital crunch has been suggested as a more apt description for the reduction in lending during this episode, in view of the role of bank capital.2The evidence from state and bank level data shows that low bank capital has been associated with sluggish lending during this period.3In addition, there is some more general evidence that the cost of loans depends on bank capital. Using a matched sample of individual loans, borrowers and banks, R. Glenn Hubbard, Kenneth N. Kuttner, and Darius N. Palia (2001) find that higher bank capital lowers the rate charged on loans, even after controlling for borrower characteristics, other bank characteristics and loan contract terms.4If bank capital is a 1I use the terms bank equity and bank capital interchangeably to refer to the book value of bank equity. I will be more precise about the regulatory definitions below. 2Richard F. Syron (1991). See also Ben S. Bernanke and Cara S. Lown (1991). 3See Steven A. Sharpe (1995) for an overview. In his judgement, the research has been less successful in determining whether this association is due to a causal effect of bank capital on loan supply or due to the effect of persistent variation in loan demand on capital. 4In addition, Joe Peek, Eric S. Rosengren and Geoffrey M. B. Tootell (1999 and 2003) show that confidential supervisory bank ratings, which partly reflect capital adequacy, predict GDP growth even when controlling for commercial or Fed forecasts of growth. Interestingly, they also find that this information is used by the FOMC in decisions on the Federal Funds target rate. 1significant determinant of loan supply, then it is important t