07 April 2016

BIS: Why bank capital matters for monetary policy

In a cross-country bank-level study, authors find that a 1 percentage point increase in the equity-to-total assets ratio is associated with a 4 basis point reduction in debt financing and with a 0.6 percentage point increase in annual loan growth.

Bank capitalisation has been central in the policy debate in the aftermath of the financial crisis. While most of the attention from financial supervisors has been on solvency issues, solvent banks may still refuse to lend. Indeed, if the banking system as a whole is weakly capitalised, there may even be some apparent tension between the monetary policy imperative of unlocking bank lending (which entails expanding credit) and the supervisory objective of ensuring the soundness of individual banks (which entails cutting back credit). Nevertheless, our main finding is that this tension is more apparent than real; both the macro objective of unlocking bank lending and the supervisory objective of sound banks are better served when bank equity is high.

Authors focus has been on the relationship between bank capital and credit, and thereby on macroeconomic conditions more broadly. In a bank-level study with time and firm fixed effects, they have found that higher bank capital is associated with greater lending, and that the mechanism involved in this channel is the lower funding costs associated with better capitalised banks.

The cost advantage of a well-capitalised bank is found to be substantial. A 1 percentage point increase in the equity-to-total-assets ratio is associated with a 4 basis point reduction in the cost of debt financing. This effect reduces to around one third the estimate of the cost of equity in total funding as typically calculated by the literature. Authors also find that such a reduction in overall funding cost translates into greater bank lending. A 1 percentage point increase in the equity-to-total-assets ratio is associated with 0.6 percentage point increase in annual credit growth.

To the extent that increased credit is an essential ingredient in the transmission of monetary policy to the real economy, their results shed light on the importance of bank capital for the monetary policy mandate of the central bank, as well as to its mandate as the financial supervisor.

Full working paper

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