Does Bank Capital Matter for Monetary Transmission?

Traditional monetary theory has largely ignored the role ofbank equity. Bank-centered accounts of how monetarypolicy affects the real economy usually focus on the role ofreserves and reserve requirements in determining the volumeof demand deposits and, in the case of the bank lendingchannel, bank loans. As Friedman (1991) observed,“Traditionally, most economists have regarded the fact thatbanks hold capital as at best a macroeconomic irrelevance andat worst a pedagogical inconvenience.” This stands in starkcontrast to the importance attached to capital adequacy in theregulation of banks, especially since the adoption of the BasleAccord in 1988, which established risk-based capitalrequirements in the Group of Ten countries. The implementationof these regulations, along with other factors, hasoften been blamed for a perceived credit crunch in the UnitedStates immediately prior to and during the 1990-91 recession,giving rise to the term “capital crunch.”1 Research on this andother episodes has found that low bank capital is associatedwith sluggish lending.