Capital requirements, bank behavior and monetary policy: A theoretical analysis with an empirical application to India

The paper addresses the issue of monetary policy transmission through the banking sector in the presence of a bank capital regulation. A model of bank behavior is presented, which shows how a monetary policy shock affects both deposit and lending, in the short run (when equity capital is assumed to be fixed) as well as in the long run (when equity is endogenous). The analysis is extended to incorporate a salient feature of Basel II incorporating loans with differential risk weights. The basic spirit of the model is empirically examined using data on Indian banks for 1993-2004. The findings indicate that constrained banks raises lending to less risky borrowers in response to a monetary contraction.