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Capital Requirement and Financial Frictions in Banking: Macroeconomic Implications

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  • Ali Dib
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Abstract

The author develops a dynamic stochastic general-equilibrium model with an active banking sector, a financial accelerator, and financial frictions in the interbank and bank capital markets. He investigates the importance of banking sector frictions on business cycle fluctuations and assesses the role of a regulatory capital requirement in propagating the effects of shocks in the real economy. Bank capital is introduced to satisfy the regulatory capital requirement, and serves as collateral for borrowing in the interbank market. Financial frictions are introduced by assuming asymmetric information between lenders and borrowers that creates moral hazard and adverse selection problems in the interbank and bank capital markets, respectively. Highly leveraged banks are vulnerable and therefore pay higher costs when raising funds. The author finds that financial frictions in the interbank and bank capital markets amplify and propagate the effects of shocks; however, the capital requirement attenuates the real impacts of aggregate shocks (including financial shocks), reduces macroeconomic volatilities, and stabilizes the economy.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 10-26.

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Length: 51 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:bca:bocawp:10-26

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Related research

Keywords: Economic models; Business fluctuations and cycles; Financial markets; Financial stability;

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References

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  2. Bojan Markovic, 2006. "Bank capital channels in the monetary transmission mechanism," Bank of England working papers 313, Bank of England.
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  20. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715, Cowles Foundation for Research in Economics, Yale University.
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  25. Ian Christensen & Ali Dib, 2008. "The Financial Accelerator in an Estimated New Keynesian Model," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(1), pages 155-178, January.
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Cited by:
  1. Hyunduk Suh, 2012. "Dichotomy between macroprudential policy and monetary policy on credit and inflation," Working Papers 13-06, Federal Reserve Bank of Philadelphia.
  2. Kozicki, Sharon, 2012. "Macro has progressed," Journal of Macroeconomics, Elsevier, vol. 34(1), pages 23-28.

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