Bank Procyclicality, Credit Crunches, and Asymmetric Monetary Policy Effects: A Unifying Model

• Published in: Journal of applied finance : JAF 2003-10, Vol.13 (2), p.23
• Main Authors: Bliss, Robert R, Kaufman, George G
• Format: Article
• Language: English
• Subjects: Balance sheets; Bank deposits; Bank earnings; Bank reserves; Banking industry; Business cycles; Capital requirements; Central banks; Economic models; Equilibrium; Federal Reserve monetary policy; Interest rates; Loans; Macroeconomics; Monetary policy; Recessions; Regulation of financial institutions; Reserve requirements; Textbooks; Volatility
• ISSN: 1534-6668

Perceived credit crunches, excessive procyclicality in bank behavior, and limited effectiveness of expansionary Fed monetary policy in economic recessions are not easily predicted by the usual simple textbook bank deposit or bank credit expansion model as outcomes of an expansive monetary policy. But, with a relatively simple modification to this model that introduces a market or regulatory capital constraint in addition to the traditional reserve constraint, it is demonstrated that all 3 effects may be predictable outcomes. Where capital requirements are binding, the model clearly shows that injection of additional reserves by the Fed may not achieve the intended increase in bank deposits and earning assets. If either constraint is binding, earning assets cannot grow further. Observed fluctuations in the level of bank capital through the business cycle-higher capital ratios during economic expansions and lower ratios during recessions-together with changes in the effective capital requirement if the ratio is risk-sensitive, are likely to create further procyclical changes in bank loans and earning assets and give rise to perceived credit crunches.