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Capital requirements, monetary policy and the fundamental problem

Capital requirements, monetary policy and the fundamental problem

by David Miles and Chuan Du

Abstract

We ask what should be the role of limits on bank capital structure and monetary policy, the latter aimed at influencing the required return on bank liabilities, in countering a tendency for banks to take excessive risks because of asymmetric information and limited liability. We find the two policy instruments operate as imperfect substitutes. A tightening of either instrument can improve ’prudence’, by disincentivising banks against undertaking lending projects with low probability of success; but only at the cost of decreased ’participation’, whereby more banks will forego the opportunity to lend. We show conditions when each instrument should be used.

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