Prudential bank regulation complicates monetary policy because it has cyclical effects on the growth of bank credit, which can be a channel through which monetary policy is transmitted to the economy. Employing a panel of 36 advanced and developing countries for the period 1973–2015, we find that changes in regulation have been procyclical with respect to credit surges and counter-cyclical with respect to credit stops. As a result, monetary policy risks being too loose over the credit cycle. The economic effects of prudential regulation on credit have been meaningful given the large-scale bank liberalizations undertaken by many countries. The result is robust to dealing with a wide range of sensitivity tests and endogeneity concerns. In designing regulations, policymakers need to consider transmission mechanisms through which they might affect the real economy and undermine the goals of monetary policy.

Bank capital requirements reduce the probability of bank failure and help mitigate taxpayers’ sharing in the losses that result from bank failures. Under Basel III, direct capital requirements are supplemented with liquidity requirements. Our results suggest that liquidity provisions of banks are connected to bank capital and that changes in liquidity indirectly affect the capital structure of financial institutions. Liquidity appears to be another instrument for adjusting bank capital structure beyond just capital requirements. Consistent with Diamond and Rajan (2005), we find that liquidity and capital should be considered jointly for promoting financial stability.

A majority of U.S. banks between 1973 and 2012 held equity capital significantly beyond the required minimum. We study the risk-return tradeoff in connection with a bank’s capital structure, and identify several new significant market factors that drive the level of equity capital in banks. During normal growth periods, bank leverage is negatively related to a level of competition and loan portfolio diversification, while high bank leverage is associated with low past liquidity. During recessions and expansions, the roles of those factors change following distortions in risk-return tradeoff. In distress, when banks approach regulatory capital requirements, market determinants of book leverage lose their significance; however, leverage does not decrease until a bank is within 1% of the minimal capital threshold.