Working Paper 2020-27
We present evidence that monetary policy easing reduces bank risk-taking but exacerbates capital misallocation in China after implementing the Basel III capital regulations in 2013. The new regulations tightened bank capital requirements and introduced a new risk-weighting approach to calculating the capital adequacy ratio (CAR). To meet tightened capital requirements, a bank can boost its effective CAR by raising capital or by increasing the share of lending to low-risk borrowers. Using confidential loan-level data from a large Chinese commercial bank, merged with firm-level data on a large set of manufacturing firms, we document robust evidence that a monetary policy expansion raises the share of new bank loans to state-owned enterprises (SOEs) after 2013, but not before, because SOE loans receive high credit ratings under government guarantees. Since SOEs are on average less productive than private firms, shifts in bank lending toward SOEs exacerbate capital misallocations, reducing aggregate productivity. We construct a two-sector general equilibrium model with bank portfolio choices and show that, under calibrated parameters, an expansionary monetary policy shock raises the share of bank lending to SOEs, leading to persistent declines in total factor productivity that partially offset the expansionary effects of monetary policy.