But the shock also leads to a large fall in the return on capital and in its price. Left unaddressed, this would lead to a sharp drop in bank profits, a decline in bank capital and a reduction in credit supply. If the leverage ratio were constant, that would reduce the amount of investment, capital and output. That effect is, however, moderated by expectations of a future recovery in the price of capital, which raises future returns on capital, thus allowing higher leverage, 13 higher bank profits and a degree of “self-healing” in the banking sector. When monetary policy is the sole instrument available (dashed red line), the nominal interest rate is cut briefly but returned to its steady-state value quickly. As described above, monetary policy is acting on aggregate demand and credit supply simultaneously. This supports output and capital but at the expense of a brief burst of inflation. The cut in the nominal interest rate helps boost the future loan-deposit spread but cannot prevent a fall in bank capital. Note also that the increase in the future loan-deposit spread pushes up the leverage ratio. The response is, though, quite different when the policy maker can deploy the macroprudential tool too (solid blue line). Now, the policy maker uses the bank levy/subsidy to prevent the sharp fall in bank capital. Monetary policy is then set to maintain output at its new, lower, efficient level with prices unchanged; that requires only a minimal change to the policy rate.
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