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.
Zamani Abdul Ghani: Malaysia - an investment destination Speech by Mr Zamani Abdul Ghani, Deputy Governor of the Central Bank of Malaysia, at the Investors’ Conference, Kuala Lumpur, 22 June 2005. *  *  *  Bismillahirrahmanirrahim Your Excellencies, Distinguished Guests, Ladies and Gentlemen, Assalamualaikum warahmatullah hiwabarakatuh and good morning, First of all, allow me to welcome all of you to this conference on "Malaysia: An Investment Destination" held in conjunction with the 30th IDB Board of Governors' Meeting. We are most heartened that there are representatives here this morning from more than one hundred global financial institutions and from over thirty countries. I would like to welcome all of you to Malaysia especially those who are here for the first time. I hope you have had a good rest after a journey from your respective countries because we have a very special program waiting for you. Indeed it is a great honour to be given the privilege to host this historic conference. The theme for the conference "Malaysia: An Investment Destination" is a fitting choice as we would highlight to you a wide range of investment opportunities available for you in Malaysia. This theme is most appropriate given a fast changing global and regional financial landscape, driven by financial liberalization and consolidation, economic transformation and more discerning and demanding investors. Ladies and gentlemen, We will do our best to ensure that this conference will be rewarding and useful for you.