Business Cycle and Bank Capital: Monetary Policy Transmission under the Basel Accords

Abstract

This paper improves the analysis of the role of financial frictions in the transmission of monetary policy and in business cycle fluctuations, by focusing on an additional channel working through bank capital. Detailing a dynamic general equilibrium model, in which households require a (countercyclical) liquidity premium to hold bank capital, we find that, together with the financial accelerator, the introduction of regulatory bank capital significantly amplifies monetary shocks through a liquidity premium effect on the external finance premium faced by firms. This amplification effect is larger under Basel II than under Basel I regulatory rules. Indeed, introducing bank capital enhances the role of financial frictions in the propagation of shocks, in line with arguments in related literature.

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