Urban Jermann (UPenn, Wharton) 01.12.2021

Bank liabilities include debt with long-term maturities and deposits that typically are not withdrawn for extended periods. This subjects bank liabilities to debt dilution. Our analysis shows that this has major effects for how monetary policy shocks are transmitted to banks and for optimal capital regulation. Interest rate cuts produce protracted increases in bank risk which are stronger in low-rate regimes. Capital regulation addresses debt dilution but is subject to a time-inconsistency problem. We compare Ramsey and Markov-perfect optimal policies and find that regulator commitment significantly impacts optimal bank capital regulation, sometimes in unexpected ways.