Monetary tightening, financial stability and the role of macroprudential policy

Series: Working Papers. 2623.

Author: Luis Herrera, Caterina Mendicino, Kalin Nikolov and Valerio Scalone

Macroprudential policy

• Crisis
• Monetary policy

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Monetary tightening, financial stability and the role of macroprudential policy (1 MB)

Abstract

This paper studies the financial stability risks and distributional effects of monetary policy tightening and the role of macroprudential policy in shaping these outcomes. We develop a macro-banking model with leveraged borrowers, banks subject to balance-sheet constraints and endogenous default. Higher policy rates increase borrower default risk and generate bank losses, amplifying the contraction in credit and disproportionately affecting financially constrained households. Structural macroprudential policies, including higher capital requirements and tighter loan-to-value caps, attenuate these effects by reducing leverage ex ante. The impact of countercyclical interventions is state-dependent: borrowerbased measures mitigate the contraction in credit faced by constrained households, while releasing capital buffers supports lending when banks are well capitalized but can amplify credit contraction when balance sheets are weak.