Procyclicality of capital requirements in a general equilibrium model of liquidity dependence

This paper quantifies the procyclical effects of bank capital requirements in a general equilibrium model where financing of capital goods production is subject to an agency problem. At the center of this problem is the interaction between entrepreneurs? moral hazard and liquidity provision by banks as analyzed by Holmstrom and Tirole (1998). We impose capital requirements under the assumption that raising funds through bank equity is more costly than through deposits. We consider the time-varying capital requirement (as in Basel II) as well as the constant requirement (as in Basel I). Importantly, under both regimes, the cost of issuing equity is higher during downturns. Comparing output fluctuations under the Basel I and Basel II economies with those in the no-requirement economy, we show that capital requirements significantly contribute to magnifying output fluctuations. The procyclicality is most pronounced around business cycle peaks and troughs.