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 findings are contrasted with those obtained under the 1988 Accord and the implications of the analysis are explored.