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A theoretical foundation for prudential authorities decision making

Author

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  • Cristina Badarau
  • Corentin Roussel

Abstract

In the aftermath of the Global Financial Crisis, financial regulation uses micro and macroprudential rules, most of the time motivated by empirical studies. This article suggests a theoretical explanation for countercyclical and progressive capital requirements that incorporate micro- and macro-prudential stabilization objectives. The Capital Adequacy Ratio (CAR) imposed to individual banks by a Prudential Authority (PA) would thus represent an optimal regulation whose aim is to avoid individual and systemic risk accumulation by imposing minimal constraints to financial institutions. This corresponds to the implementation of optimal time-varying prudential capital requirements to banks, with non-linear structure, that allows PA to take progressive countercyclical actions in order to ensure financial stability. We also test the mechanism in a DSGE model and show that it would be more suitable for the financial and real stability compared to the existing fixed prudential ratios.

Suggested Citation

  • Cristina Badarau & Corentin Roussel, 2022. "A theoretical foundation for prudential authorities decision making," International Economics, CEPII research center, issue 172, pages 421-462.
    • Handle: RePEc:cii:cepiie:2022-q3-172-33
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    Keywords

    Prudential regulation model; Optimal CAR; Time-varying capital requirements; DSGE model;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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