Few areas of monetary economics have been studied as extensively as the transmission mechanism. The literature on this topic has evolved substantially over the years, following the waxing and waning of conceptual frameworks and the changing characteristics of the financial system. In this paper, taking as a starting point a brief overview of the extant work on the interaction between capital regulation, the business cycle and the transmission mechanism, we offer some broader reflections on the characteristics of the transmission mechanism in light of the evolution of the financial system. We argue that insufficient attention has so far been paid to the link between monetary policy and the perception and pricing of risk by economic agents—what might be termed the “risk-taking channel” of monetary policy. We develop the concept, compare it with current views of the transmission mechanism, explore its mutually reinforcing link with “liquidity” and analyse its interaction with monetary policy reaction functions. We argue that changes in the financial system and prudential regulation may have increased the importance of the risk-taking channel and that prevailing macroeconomic paradigms and associated models are not well suited to capturing it, thereby also reducing their effectiveness as guides to monetary policy.

This paper measures the systemic risk of a banking sector as a hypothetical distress insurance premium, identifies various sources of financial instability, and allocates systemic risk to individual financial institutions. The systemic risk measure, defined as the insurance cost to protect against distressed losses in a banking system, is a summary indicator of market perceived risk that reflects expected default risk of individual banks, risk premia as well as correlated defaults. An application of our methodology to a portfolio of twenty-two major banks in Asia and the Pacific illustrates the dynamics of the spillover effects of the global financial crisis to the region. The increase in the perceived systemic risk, particularly after the failure of Lehman Brothers, was mainly driven by the heightened risk aversion and the squeezed liquidity. Further analysis, which is based on our proposed approach to quantifying the marginal contribution of individual banks to the systemic risk, suggests that “too-big-to-fail” is a valid concern from a macro-prudential perspective of bank regulation.