Bank capitalization heterogeneity and monetary policy

Peter Paz

No 2234, Working Papers from Banco de España

Abstract: This paper shows that heterogeneity in bank capitalization ratios plays a crucial role in the transmission of monetary policy to bank lending. First, I offer new empirical evidence on how banks’ lending responses to monetary policy shocks depend on their capitalization ratios. Highly capitalized banks reduce their lending more after a monetary tightening, even after controlling for bank liquidity, size and market power in the deposit market. I also document how highly capitalized banks have a riskier portfolio, as measured by loan charge-off rates, and default rates on their loans increase relatively more after a tightening in monetary policy. I then construct a dynamic macroeconomic model that rationalizes the empirical evidence through the interaction of the heterogeneous recovery technologies of banks facing a risk-weighted capital constraint. In particular, after an increase in the policy rate, the model predicts that loan rates and default probabilities increase in both sectors. Highly capitalized banks with a riskier portfolio are more sensitive because the risk-weighted capital constraint affects them more, so they contract lending more. In a counterfactual analysis, I find higher capital requirements amplify the effects of monetary policy.

Keywords: monetary policy; banks; heterogeneity (search for similar items in EconPapers)
JEL-codes: E43 E52 E58 E60 G21 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2022-10
New Economics Papers: this item is included in nep-cba, nep-des, nep-dge, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:bde:wpaper:2234

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