Bank capital and monetary policy transmission: Analyzing the central bank’s dilemma

This paper examines the role of bank capital in the transmission of monetary policy in a large emerging economy where banks are the primary channel of financial intermediation as well as the main conduit of monetary transmission. We analyze whether differences in capital levels influence how banks adjust credit supply in response to changes in policy rates. We find that while monetary tightening reduces credit growth, banks with higher capital levels are significantly less sensitive to monetary policy changes. This suggests that higher capital levels dampen the impact of policy tightening, potentially weakening monetary policy transmission. We also find that this mitigating effect diminishes during periods of balance sheet stress when banks’ ability to absorb shocks is limited. These results highlight a key policy trade-off for central banks: preserving financial stability while ensuring effective transmission of monetary policy.