The Welfare Cost of Banking Regulation
AbstractThe Basel Accords promote the adoption of capital adequacy requirements to increase the banking sector's stability. Unfortunately, this type of regulation can hamper economic growth by shifting banks' portfolios from more productive risky investment projects toward less productive but safer projects. This paper introduces banking regulation in an overlapping-generations model and studies how it affects economic growth, banking sector stability, and welfare. In this model, a banking crisis is the outcome of a productivity shock, and banking regulation is modeled as a constraint on the maximal share of banks' portfolios that can be allocated to risky assets. This model allows us to evaluate quantitatively the key trade-off, inherent in this type of regulation, between ensuring banking stability and fostering economic growth. The model implies an optimal level of regulation that prevents crises but at the same time is detrimental to growth. We find that the overall effect of optimal regulation on social welfare is positive when productivity shocks are sufficiently high and economic agents are sufficiently risk-averse.
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Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 7588.
Date of creation: 15 Oct 2007
Date of revision:
Overlapping Generations; Competitive Equilibrium; Economic Growth; Banking Regulation;
Other versions of this item:
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- D92 - Microeconomics - - Intertemporal Choice - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-03-15 (All new papers)
- NEP-BAN-2008-03-15 (Banking)
- NEP-DGE-2008-03-15 (Dynamic General Equilibrium)
- NEP-MAC-2008-03-15 (Macroeconomics)
- NEP-REG-2008-03-15 (Regulation)
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