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Researchers warn that a weaker banking system amplifies the impact of monetary policy and contributes to economic instability. Banks’ capital buffers are best augmented during times of affluence, when looser monetary policy can mitigate the costs of increasing capital requirements.
Since the financial crisis, central banks and regulatory authorities have been given new powers to set macroprudential bank capital requirements. It is therefore important to understand how these instruments affect the economy at large.
This analysis carries a key lesson for policymakers: the health of banks and the nature of macroprudential policy matter a lot for monetary policy transmission. A weaker banking system amplifies the impact of monetary policy but also contributes to economic instability and the need for ultra-loose monetary policy in the aftermath of crises. Macroprudential measures that put banks on a sounder financial footing and tame the financial cycle bring an additional benefit by eliminating periods when the economy needs deeply negative real interest rates.
However, as their model comparison reveals, activating a macroprudential capital measure carries short-term costs to economic activity. These costs could be larger when banks deleverage quickly while paying dividends to shareholders, and when monetary policy cannot respond due to a binding effective lower bound on nominal interest rates, which underscores the need for truly countercyclical macroprudential policy. Regulators should build banks’ capital buffers during good times, when banks can issue new equity and when looser monetary policy can mitigate the costs of increasing capital requirements.