Unconventional Monetary Policy and the Safety of the Banking System
USC-INET Research Paper No. 17-04
48 Pages Posted: 29 May 2016 Last revised: 2 Feb 2017
Date Written: May 28, 2016
This paper presents a simple model of banking equilibrium in which unconventional monetary policy serves as a tool to enhance the safety of the banking system. Every economy has two intrinsic characteristics: a "natural" debt-equity ratio which depends on the endowments of the infinitely risk averse safe-debt providers and the risk neutral equity providers, and a "critical" debt-equity ratio which depends only on the risks inherent in the banks' productive loans. When the natural debt-equity ratio exceeds the critical ratio, there is a positive probability of bankruptcy in equilibrium. In such "high debt" economies, standard banking equilibria are inefficient regardless of the capital requirement imposed by regulators. However unconventional monetary policy using the balance sheet of the Central Bank in conjunction with an adequate capital requirement can restore the Pareto optimality of the banking equilibrium.
Keywords: safe asset, banking equilibrium, natural equity-to-capital ratio, critical equity-to-capital ratio, Central Bank prudential policy, interest on reserves, asset purchases
JEL Classification: E 58, G21, G28
Suggested Citation: Suggested Citation