Credit channel and risk-based capital adequacy requirements

Introduction: Importance of bank lending in the propagation of exogenous shocks has been recognised in the literature. Such views are collectively called the credit view. The credit view is that a negative shock, e.g. a monetary tightening, restricts the availability of credit to borrowers, thereby affecting the real economy. The credit view consists of two different views, namely the “bank-lending view” and the “balance sheet view”. According to the “bank-lending view” banks cut back on lending in the wake of tight money because they have less money to lend, even though there are good loans to be made. On the other hand, the balance sheet view implies that banks cut back on lending in the wake of tight money because borrowers are in bad shape. Thus the two views have different implications. Nevertheless, both the views imply that a monetary tightening shifts the supply schedule of bank loans left, thereby affecting the real economy. This transmission mechanism of monetary policy is called the credit channel. The quantitative importance of the credit channel may be dependent on institutional characteristics of the financial market. If banks can substitute from deposits to less reserve-intensive forms of finance, such as certificates of deposit, commercial paper, and equity, for instance a reduction in bank reserves caused by a monetary tightening will not shift the supply schedule of bank loans. If borrowers have access to a variety of non-bank financial sources, for instance, a leftward shift of the supply schedule of bank loans, if any, will not affect the real economy. As such, it is argued in the literature that the importance of the credit channel is likely to diminish over time due to ongoing financial innovation and deregulation, e.g. Bernanke and Gertler. There may be institutional changes that make the credit channel of monetary policy more important however. An example of such institutional changes may be the introduction of the risk-based capital standard