Does Bank Capital Matter for Monetary Transmission?

raditional monetary theory has largely ignored the role of bank equity. Bank-centered accounts of how monetary policy affects the real economy usually focus on the role of reserves and reserve requirements in determining the volume of demand deposits and, in the case of the bank lending channel, bank loans. As Friedman (1991) observed, “Traditionally, most economists have regarded the fact that banks hold capital as at best a macroeconomic irrelevance and at worst a pedagogical inconvenience.” This stands in stark contrast to the importance attached to capital adequacy in the regulation of banks, especially since the adoption of the Basle Accord in 1988, which established risk-based capital requirements in the Group of Ten countries. The implementation of these regulations, along with other factors, has often been blamed for a perceived credit crunch in the United States immediately prior to and during the 1990-91 recession, giving rise to the term “capital crunch.”1 Research on this and other episodes has found that low bank capital is associated with sluggish lending. Despite this evidence, the role of bank capital and capital requirements in the monetary transmission mechanism has received much less attention.3 This paper addresses this issue by examining how bank capital and its regulation affect the role of bank lending in the transmission of monetary policy. I argue that taking into account bank capital has some interesting implications for our understanding of the monetary transmission mechanism. In addition, I briefly discuss whether recently adopted and proposed amendments to the Basle Accord can be expected to change these implications.