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The welfare cost of banking regulation

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  • Tchana Tchana, Fulbert

Abstract

The 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 initiated by an aggregated shock (in the risky sector) in a banking system with implicit bailout, 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 (for example, in the subprime banking crisis episode) and economic agents are sufficiently risk-averse. Finally, we find that there is a trade-off between regulating the economy upfront (i.e. before the shock) and facing the challenge of making a huge bailout after the crisis.

Suggested Citation

  • Tchana Tchana, Fulbert, 2012. "The welfare cost of banking regulation," Economic Modelling, Elsevier, vol. 29(2), pages 217-232.
  • Handle: RePEc:eee:ecmode:v:29:y:2012:i:2:p:217-232 DOI: 10.1016/j.econmod.2011.09.005
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    Cited by:

    1. Rubio, Margarita & Carrasco-Gallego, José A., 2016. "The new financial regulation in Basel III and monetary policy: A macroprudential approach," Journal of Financial Stability, Elsevier, vol. 26(C), pages 294-305.
    2. Tchana Tchana, Fulbert, 2014. "The empirics of banking regulation," Emerging Markets Review, Elsevier, vol. 19(C), pages 49-76.
    3. Hamed Ghiaie, 2017. "Credit Crunch On Financial Intermediary," THEMA Working Papers 2017-09, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
    4. Banerji, Sanjay & Basu, Parantap, 2017. "Universal banking, asymmetric information and the stock market," Economic Modelling, Elsevier, vol. 60(C), pages 180-193.
    5. Bilin Neyapti, 2010. "Macroeconomic Institutions and Development," Books, Edward Elgar Publishing, number 12960, April.
    6. repec:cmj:journl:y:2013:i:29:gutu is not listed on IDEAS
    7. Lavinia Mihaela GUȚU & Vasile ILIE, 2013. "Banking supervision in European Union," SEA - Practical Application of Science, Fundația Română pentru Inteligența Afacerii, Editorial Department, issue 2, pages 121-130, October.
    8. Kilinc, Mustafa & Neyapti, Bilin, 2012. "Bank regulation and supervision and its welfare implications," Economic Modelling, Elsevier, vol. 29(2), pages 132-141.

    More about this item

    Keywords

    Overlapping generations; Competitive equilibrium; Economic growth; Subprime banking crisis; Banking regulation; Banking bailout;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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