Rule-Based Micro and Macro-Prudential Policy in a Heterogeneous Banking Network

Abstract

This paper investigates the effects of rule-based prudential policies on the banks competition in the deposit market. Using the imperfect competition structure and focusing on heterogeneous banks, we develop a partial equilibrium model, under which implications of how capital adequacy ratio regulation is implemented either discriminatory between banks (micro) or non-discriminatory and uniformly for all banks (macro) will be analyzed. Among the features that are emphasized in this analytical model is the role of self-regulation of bank capital in building confidence in the banking network in a non-linear manner. This, in a range of capital adequacy ratios, has featured the use of that prudential policy tool as a self-defeating one for the policymaker's goal in curbing the portion of high-risk projects in the targeted bank's assets portfolio. Further, a channel to explain the role of monetary policy in establishing stability or fragility of the banking network is introduced. In particular, the role of investors' degree of risk aversion in motivating banks to set their monitoring efforts has been evaluated.

Keywords

• capital adequacy ratio
• imperfect market
• rule-based prudential policy
• contagion risk