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Optimal capital requirements over the business and financial cycles

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  • Malherbe, Frederic

Abstract

I study economies where banks do not fully internalize the social costs of default, which distorts their lending decisions. In all these economies, a common general equilibrium effect leads to aggregate over-investment. As a result, under laissez-faire, crises are too frequent and too costly from a social point of view. In response, the regulator sets a capital requirement to trade off expected output against financial stability. The capital requirement that ensures investment efficiency depends on the state of the economy. Because of the general equilibrium effect, the more aggregate banking capital the tighter the optimal requirement. A regulation that fails to take this effect into account exacerbates economic fluctuations and allows for excessive build-up of risk in the financial sector during booms. Government guarantees amplify this mechanism and, at the peak of a boom, even a small adverse shock can trigger a banking sector collapse, followed by an excessively severe credit crunch. JEL Classification: E44, G01, G21, G28

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  • Malherbe, Frederic, 2015. "Optimal capital requirements over the business and financial cycles," Working Paper Series 1830, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20151830
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    Citations

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    Cited by:

    1. Bahaj, Saleem & Bridges, Jonathan & Malherbe, Frederic & O’Neill, Cian, 2016. "What determines how banks respond to changes in capital requirements?," Bank of England working papers 593, Bank of England.
    2. Pierluigi Bologna & Anatoli Segura, 2016. "Integrating stress tests within the Basel III capital framework: a macroprudentially coherent approach," Questioni di Economia e Finanza (Occasional Papers) 360, Bank of Italy, Economic Research and International Relations Area.
    3. Elena Afanasyeva & Jochen Güntner, 2014. "Lending Standards, Credit Booms and Monetary Policy," Economics working papers 2014-11, Department of Economics, Johannes Kepler University Linz, Austria.
    4. Gete, Pedro & Tiernan, Natalie, 2014. "Lending Standards and Countercyclical Capital Requirements under Imperfect Information," MPRA Paper 54486, University Library of Munich, Germany.
    5. Frederic Malherbe, 2015. "Optimal Capital Requirements over the Business and Financial Cycles," 2015 Meeting Papers 1154, Society for Economic Dynamics.
    6. Pierre-Richard Agénor & L. Pereira da Silva, 2016. "Capital Requirements, Risk Taking and Welfare in a Growing Economy," Centre for Growth and Business Cycle Research Discussion Paper Series 226, Economics, The Univeristy of Manchester.
    7. Malherbe, Frederic, 2015. "Optimal capital requirements over the business and financial cycles," Working Paper Series 1830, European Central Bank.
    8. Bahaj, Saleem & Malherbe, Frédéric, 2016. "A positive analysis of bank behaviour under capital requirements," CEPR Discussion Papers 11607, C.E.P.R. Discussion Papers.
    9. repec:eee:moneco:v:90:y:2017:i:c:p:113-124 is not listed on IDEAS
    10. Jef Boeckx & Maite De Sola Perea & Gert Peersman, 2016. "The Transmission Mechanism Of Credit Support Policies In The Euro Area," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 16/926, Ghent University, Faculty of Economics and Business Administration.
    11. Carvallo, Oscar & Pagliacci, Carolina, 2013. "Macroeconomic Shocks, Housing Market and Banks’ Performance in Venezuela," MPRA Paper 58711, University Library of Munich, Germany, revised Jul 2014.
    12. Pierre-Richard Agénor & L. Pereira da Silva, 2016. "Capital Requirements, Risk Taking and Welfare in a Growing Economy," Centre for Growth and Business Cycle Research Discussion Paper Series 226, Economics, The Univeristy of Manchester.
    13. Gersbach, Hans & Rochet, Jean-Charles, 2017. "Capital regulation and credit fluctuations," Journal of Monetary Economics, Elsevier, pages 113-124.
    14. Tetiana Davydiuk, 2017. "Dynamic Bank Capital Requirements," 2017 Meeting Papers 1328, Society for Economic Dynamics.

    More about this item

    Keywords

    Basel regulation; capital requirement; countercyclical buffers; financial cycles; financial regulation; overinvestment;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • 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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