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

See all articles by Michael J. P. Magill

Michael J. P. Magill

University of Southern California - Department of Economics

Martine Quinzii

University of California, Davis - Department of Economics

Jean-Charles Rochet

GFRI, University of Geneva; Swiss Finance Institute; University of Zurich - Swiss Banking Institute (ISB)

Date Written: May 28, 2016

Abstract

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

Magill, Michael J. P. and Quinzii, Martine and Rochet, Jean-Charles, Unconventional Monetary Policy and the Safety of the Banking System (May 28, 2016). USC-INET Research Paper No. 17-04. Available at SSRN: https://ssrn.com/abstract=2786216 or http://dx.doi.org/10.2139/ssrn.2786216

Michael J. P. Magill

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall, 300
Los Angeles, CA 90089
United States
213-740-2104 (Phone)
213-740-8543 (Fax)

Martine Quinzii (Contact Author)

University of California, Davis - Department of Economics ( email )

One Shields Drive
Davis, CA 95616-8578
United States
530-752-1567 (Phone)
530-752-9382 (Fax)

Jean-Charles Rochet

GFRI, University of Geneva ( email )

102 Bd Carl-Vogt
Genève, CH - 1205
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

University of Zurich - Swiss Banking Institute (ISB) ( email )

Plattenstrasse 14
CH-8032 Zurich, Zurich 8032
Switzerland

Register to save articles to
your library

Register

Paper statistics

Downloads
123
Abstract Views
691
rank
232,404
PlumX Metrics