A Tale of Two Policies: Prudential Regulation and Monetary Policy with Fragile Banks

We introduce banks, modeled as in Diamond and Rajan (JoF 2000 or JPE 2001), into a

standard DSGE model and use this framework to study the role of banks in the transmission of

shocks, the effects of monetary policy when banks are exposed to runs, and the interplay between

monetary policy and Basel-like capital ratios. In equilibrium, bank leverage depends positively

on the uncertainty of projects and on the bank’s "relationship lender" skills, and negatively on

short term interest rates. A monetary restriction reduces leverage, while a productivity or asset

price boom increases it. Procyclical capital ratios are destabilising; monetary policy can only

partly offset this effect. The best policy combination includes mildly anticyclical capital ratios

and a response of monetary policy to asset prices or leverage.