9 - Regulatory policy and the new paradigm

Summary

Traditionally, monetary policy and financial regulatory policy are treated as distinct subjects. One is, fundamentally, a branch of macro–economics, the other a rather applied branch of microeconomics. One is concerned with money supply, the other with the safety and soundness of banks. In part I, however, we argued that monetary policy affects the level of economic activity through its impact on the supply of credit, mediated through the banking system. We analyzed how changes in policy – from open market operations to reserve requirements to capital adequacy standards – affected banks' incentives to lend and the constraints they face (their opportunity set). We showed that both traditional monetary instruments and regulatory provisions affected the incentives and constraints of banks. Monetary policy and financial regulatory policy are intertwined: both are relevant both for the level of aggregate economic activity and for the safety and soundness of the banking system. And just as monetary policy often went awry because of its failure to focus on how monetary and regulatory policies affected bank behavior, so too, as we shall see in this chapter, has regulatory policy often been misguided. The analysis of regulatory policy must begin with an analysis of how various regulations affect banks' behavior, and that must rest on an analysis of how the incentives and opportunity sets (constraints) are altered.