Bank risk in flux: policy interplay under uncertainty

This paper develops a theoretical model incorporating return uncertainty to examine the interaction between monetary policy and capital regulation on bank risk-taking. Even without aggregate risk, uncoordinated policies can elevate systemic risk. Bank decisions depend on both monetary policy rates and capital requirements. The analysis shows that restrictive monetary policy, when not aligned with capital regulation, amplifies bank risk-taking through a risk appetite channel, where high interest rates and stringent capital thresholds jointly increase systemic risk. A numerical example with realistic parameters illustrates these effects. Aligning these policies mitigates excessive risk-taking and supports financial stability.