Unconventional Monetary Policy and the Safety of the Banking System

This paper presents a simple general equilibrium model which simultaneously incorporates the banking sector and the monetary and macroprudential policy of the Central Bank. Banks are viewed as intermediaries which channel funds from cash pools and depositors who insist on the complete safety of their funds, and investors who accept risks, to borrowers who invest in risky projects. Bank debt is rendered safe by the explicit or implicit guarantee of the government. The presence of cash pools which can either buy (short-term) government bills or lend to banks implies that the choice of an interest rate by the Central Bank determines the cost of funds for the banks. The government insurance of debt gives it an advantage over equity which implies that capital requirements are needed to limit bank leverage. The paper studies the possible monetary and prudential policies of the Central Bank and their effect on the banking equilibrium, for economies with a high demand for a safe asset—a notion precisely defined in the paper. We show that the conventional monetary and prudential tools, the interest rate and the capital requirements of banks, are not independent instruments, and that there is no choice of policy which can lead to a Pareto optimum. However enlarging the monetary policy toolkit by adding the payment of interest on bank reserves and QE policies can, in conjunction with appropriate capital requirements, restore the Pareto optimality of the banking equilibrium.