Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism?

45 Pages Posted: 27 Jan 2009

See all articles by Claudio E. V. Borio

Claudio E. V. Borio

Bank for International Settlements (BIS) - Research and Policy Analysis

Haibin Zhu

Bank for International Settlements (BIS)

Date Written: December 1, 2008

Abstract

Few areas of monetary economics have been studied as extensively as the transmission mechanism. The literature on this topic has evolved substantially over the years, following the waxing and waning of conceptual frameworks and the changing characteristics of the financial system. In this paper, taking as a starting point a brief overview of the extant work on the interaction between capital regulation, the business cycle and the transmission mechanism, we offer some broader reflections on the characteristics of the transmission mechanism in light of the evolution of the financial system. We argue that insufficient attention has so far been paid to the link between monetary policy and the perception and pricing of risk by economic agents - what might be termed the "risk-taking channel" of monetary policy. We develop the concept, compare it with current views of the transmission mechanism, explore its mutually reinforcing link with "liquidity" and analyse its interaction with monetary policy reaction functions. We argue that changes in the financial system and prudential regulation may have increased the importance of the risk-taking channel and that prevailing macroeconomic paradigms and associated models are not well suited to capturing it, thereby also reducing their effectiveness as guides to monetary policy.

Keywords: risk-taking channel, transmission mechanism, capital regulation, procyclicality

JEL Classification: E44, E51, E52, G12, G21, G28

Suggested Citation

Borio, Claudio E.V. and Zhu, Haibin, Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism? (December 1, 2008). BIS Working Paper No. 268, Available at SSRN: https://ssrn.com/abstract=1334132 or http://dx.doi.org/10.2139/ssrn.1334132

Claudio E.V. Borio (Contact Author)

Bank for International Settlements (BIS) - Research and Policy Analysis ( email )

CH-4002 Basel, Basel-Stadt
Switzerland

Haibin Zhu

Bank for International Settlements (BIS) ( email )

Hong Kong
Hong Kong
852 2878 7145 (Phone)
852 2878 7123 (Fax)

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