Capital regulation and banking bubbles

This paper develops a dynamic general equilibrium model in infinite horizon with a regulated banking sector. We borrow the methodology of Miao and Wang (2015) to analyse how Basel capital requirement recommendations may generate and affect banking bubbles and macroeconomic key variables. We show that when banks face capital requirements based on credit risk, as in Basel I, bubbles cannot exist. Alternatively, under a regulatory framework where capital requirements are based on Value-at-Risk, as in Basel II and III, two different equilibria emerge and can coexist: the bubbleless and the bubbly equilibria. Bubbles can be positive or negative, depending on the tightness of capital requirements based on Value-at-Risk. We find a maximum value of capital requirement below which bubbles are positive and provide a larger welfare compared to the bubbleless equilibrium. Our results also suggest that a change in banking policies might lead to a crisis without external shocks.