How important are capital requirements for controlling broad money supply?

Question

Interestingly, the Bank of England (BoE) is one of the few central banks that does not have reserve requirements.

Canada, the UK, New Zealand, Australia, Sweden and Hong Kong have no reserve requirements.

This does not mean that banks can—even in theory—create money without limit. On the contrary, banks are constrained by capital requirements, which are arguably more important than reserve requirements even in countries that have reserve requirements. [...]

Even in the United States, which retains formal (though now mostly irrelevant) reserve requirements, the notion of controlling the money supply by targeting the quantity of base money fell out of favor many years ago, and now the pragmatic explanation of monetary policy refers to targeting the interest rate to control the broad money supply.

The first fact, i.e. that the BoE has no reserve requirements is easily confirmed from a 2014 BoE paper by McLeay et al.... which also strongly states the fact from the 3rd paragraph above (monetary policy as the ultimate control on broad money creation.)

On the other hand, the (unsourced) Wikipedia claim that capital requirements are (also) a brake on the creation of broad money is, interestingly, impossible for me to find the McLeay paper. So, how important are capital requirements for controlling broad money supply?

E.g., are there some [semi-]official statements by the major central banks: Fed, ECB, or even BoE on this alleged importance of capital requirements as a control of broad money supply? (I know the central banks [probably] don't entirely control these capital requirements, in the EU at least. On the other hand, it looks like the Fed does have some control over the capital requirements.)

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FWIW, I found a blog which is partially contradicting Wikipedia:

capital adequacy requirements don't limit the ability of banks to create money when the economy is doing well. However, they do limit the ability of banks to create money when the economy is doing badly.

Answer 1

On different banks, and at different times, different regulatory constraints may bind on their ability to create money:

• Reserve requirements relate bank lending (bank assets) to the quantity of reserves held by that bank at the central bank.
• Capital requirements relate bank lending to the amount of equity capital of the bank.
• Liquidity requirements relate the asset market liquidity of a bank's assets to the tenor of a bank's funding.
• Stress tests attempt to model the liquidity and/or solvency of a bank under an adverse scenario that affects the value of assets on its balance sheet and/or its funding.

In today’s environment, capital requirements and liquidity requirements are the constraints most likely to be binding on US banks, though stress tests were also binding on some banks in the recent past. Reserve requirements don’t currently bind in the US, as banks are awash in reserves, and as noted in the question, many other countries do not have these requirements.

The fact that capital requirements are a brake on money creation is quite straightforward: if a bank that is constrained by capital requirements wishes to lend more, it must first raise costly equity capital. As a result, capital requirements are by definition a structural constraint on money creation.

Having said that, capital requirements are not a tool that one uses primarily to control the money supply. Instead, they're used as a prudential measure to ensure the solvency of banks. This is because, in the framework of instruments and targets, capital requirements are a very poor instrument with which to affect either of the two main targets of monetary policy, inflation and unemployment.

They're a poor instrument for these purposes for at least three reasons: (1) the relationship between capital requirements and money creation is in no way linear— as noted before, capital requirements are binding on different institutions at different times, so it's difficult to predict the effects of tightening or loosening them; (2) changing capital requirements has a lot of consequences (such as the potential impact on bank solvency, and cost to banks of raising additional capital or shedding assets if a tightening of requirements puts banks over the new, lower limit); and (3) capital requirements affect only banks, while over half of financial intermediation occurs outside banks.

Conversely, interest rates are pretty good at affecting broad money supply, and in a really efficient way, as marginal lending opportunities are compared to the price of money. At the same time, interest rates are pretty useless as a prudential instrument, as demonstrated in the early 2000s.

Answer 2

Just adding in a couple points.

• “Broad” money supply definitions typically include non-bank finance, and the notion of “capital requirements” will not really apply to those actors.
• Even if regulators let banks do whatever they want, most banks have some notion of self-preservation. Their balance sheet expansion is limited by their ability to find credit-worthy customers who want to borrow. Since such customers (by definition) want to avoid default, lending growth is constrained by the non-financial sectors repayment capacity and risk tolerance.

Answer 3

I found a recent research paper (Faure and Gersbach) "Money Creation and Destruction" using equilibrium modelling to explore the issue, theoretically:

We examine the role of capital regulation with regard to money creation. [...]

The analysis of our model produces three main insights.

First, with perfectly flexible prices, i.e. prices adjusting perfectly to macroeconomic conditions, equilibria with money creation are associated with the first-best allocation, regardless of the central bank's monetary policy. If prices are rigid, there exist central bank policies for which money creation collapses or explodes. In the only equilibrium possible, in these cases, there is no financial intermediation, and an inefficient allocation occurs. Appropriate central bank policy can restore socially efficient money creation and lending.
Second, with price rigidities and the zero lower bound, there may not exist a feasible central bank monetary policy inducing socially efficient money creation and lending. Capital regulation in the form of a minimum equity ratio and monetary policy can jointly limit money creation and under normal economic conditions [and?] restore the existence of equilibria with socially efficient money creation and lending.
Third, when prices are rigid, the central bank's choice of zero interest rates and appropriate capital regulation can only avoid a slump in money creation and lending if economic conditions are sufficiently favorable.

[...]

we obtain three further main insights: First, in the presence of financial frictions, we are able to show that there are equilibria with banks only when capital regulation is adequately combined with monetary policy. Second, we demonstrate that there are inefficient asymmetric equilibria with banks when prices are flexible and that capital requirements that are sufficiently high eliminate these inefficient equilibria with banks, so that only ecient equilibria with banks remain. Finally, we prove that the impact of a reserve requirement coupled with a haircut rule on money creation is identical to the one of a minimum equity ratio requirement.

The last bit is also interesting (although it wasn't a direct part of my question): an equivalence of sorts between capital and reserve requirements.

Trivia: they're citing McLeay (2014) as part of the motivation for their research... I suspect there will be more papers like this.

Faure also has a somewhat longer PhD thesis which is basically on the same issue (based on its abstract) although the thesis has a much more click-bait/scary title "Inside money creation out of thin air: a general equilibrium perspective".