Capital Requirement and Financial Frictions in Banking: Macroeconomic Implications
AbstractThe 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 InfoPaper provided by Bank of Canada in its series Working Papers with number 10-26.
Length: 51 pages
Date of creation: 2010
Date of revision:
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Economic models; Business fluctuations and cycles; Financial markets; Financial stability;
Find related papers by JEL classification:
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G1 - Financial Economics - - General Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-11-06 (All new papers)
- NEP-BAN-2010-11-06 (Banking)
- NEP-BEC-2010-11-06 (Business Economics)
- NEP-CBA-2010-11-06 (Central Banking)
- NEP-CTA-2010-11-06 (Contract Theory & Applications)
- NEP-DGE-2010-11-06 (Dynamic General Equilibrium)
- NEP-MAC-2010-11-06 (Macroeconomics)
- NEP-REG-2010-11-06 (Regulation)
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