The positive neutral countercyclical capital buffer

We reconcile theory and recent evidence on the benefits of building releasable bank capital buffers when there is headroom for doing so by building a quantitative macro-banking model that provides a rationale for static bank capital requirements and dynamic capital buffers due to externalities arising from bank risk failure and collateral constraints. Optimal dynamic capital buffers gradually build in response to expected upward shifts in bank net interest margins. In the absence of pecuniary externalities due to collateral constraints, such capital buffers are ineffective. The model also captures previous empirical findings such as the negative effect of a capital requirement tightening on short-term lending and the optimality of setting static bank capital requirements at relatively conservative levels. We present an application of our quantitative analysis in the form of a simple framework for calibrating the so-called ‘positive neutral counter-cyclical capital buffer’ (PN-CCyB).