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Procyclicality of Capital Requirements in a General Equilibrium Model of Liquidity Dependence

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Author Info

  • Francisco Covas

    (Division of Monetary Affairs, Board of Governors of the Federal Reserve System)

  • Shigeru Fujita

    (Research Department, Federal Reserve Bank of Philadelphia)

Abstract

This paper quantifies the procyclical effects of bank capital requirements in a general equilibrium model where financing of capital goods production is subject to an agency problem. At the center of this problem is the interaction between entrepreneurs’ moral hazard and liquidity provision by banks as analyzed by Holmstrom and Tirole (1998). We impose capital requirements under the assumption that raising funds through bank equity is more costly than raising it through deposits. We consider the time-varying capital requirement (as in Basel II) as well as the constant requirement (as in Basel I). Importantly, under both regimes, the cost of issuing equity is higher during downturns. Comparing output fluctuations under the Basel I and Basel II economies with those in the no-requirement economy, we find that the regulations have relatively minor average effects on output fluctuations (measured by the differences in the standard deviations). However, the effects are more pronounced around business cycle peaks and troughs.

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Bibliographic Info

Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 6 (2010)
Issue (Month): 34 (December)
Pages: 137-173

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Handle: RePEc:ijc:ijcjou:y:2010:q:4:a:7

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  1. Skander Van den Heuvel, 2005. "The Welfare Cost of Bank Capital Requirements," 2005 Meeting Papers 880, Society for Economic Dynamics.
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Cited by:
  1. Alexis Derviz & Jakub Seidler, 2012. "Coordination Incentives in Cross-Border Macroprudential Regulation," Working Papers 2012/08, Czech National Bank, Research Department.
  2. Ian Christensen & Césaire Meh & Kevin Moran, 2011. "Bank Leverage Regulation and Macroeconomic Dynamics," CIRANO Working Papers 2011s-76, CIRANO.
  3. Martin Berka & Christian Zimmermann, 2012. "Basel Accord and Financial Intermediation: The Impact of Policy," Working Paper Series 04_12, The Rimini Centre for Economic Analysis.
  4. Collard, F. & Dellas, H. & Diba, B. & Loisel, O., 2012. "Optimal Monetary and Prudential Policies," Working papers 413, Banque de France.
  5. Radde, Sören, 2012. "Liquidity Crises, Banking, and the Great Recession," Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 65408, Verein für Socialpolitik / German Economic Association.
  6. Tommaso Trani, 2012. "Countercyclical Capital Regulation and Bank Ownership Structure," IHEID Working Papers 14-2012, Economics Section, The Graduate Institute of International Studies.
  7. Sören Radde, 2012. "Flight-to-Liquidity and the Great Recession," Discussion Papers of DIW Berlin 1242, DIW Berlin, German Institute for Economic Research.
  8. Matthieu Darracq Pariès & Christoffer Kok Sørensen & Diego Rodriguez Palenzuela, 2010. "Macroeconomic propagation under different regulatory regimes: Evidence from an estimated DSGE model for the euro area," Working Paper Series 1251, European Central Bank.

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