HBANK: Monetary Policy with Heterogeneous Banks

Title: HBANK: Monetary Policy with Heterogeneous Banks

Abstract: We study monetary and prudential policy transmission in a Heterogeneous Bank New Keynesian (HBANK) model with endogenous bank default risk. There is a trade-off between macroeconomic and financial stabilization: contractionary monetary policy worsens financial stability by shrinking bank net worth, thereby raising aggregate default likelihood and cost. Addressing persistent inflationary pressure comes at the cost of exacerbating financial instability. Systematic micro-prudential policy — targeting only the top quartile of banks — effectively mitigates the macroeconomic stabilization-financial stability tradeoff. We provide empirical evidence supporting the heterogeneous effects of monetary policy on bank assets and insolvency probabilities, reinforcing the necessity of incorporating bank-level heterogeneity in monetary policy design.