Global Capital Flows and the Role of Macroprudential Policy

Can countercyclical bank capital requirements reduce the negative effects ofglobal liquidity shocks? We use the Lehman Brothers bankruptcy as a natural experiment to document the role of the banking system as a transmission channel of global financial disturbances to domestic economies. Using granular and confidential data from the Bank of Portugal, our results suggest that in the aftermath of the Lehman collapse, domestic firms cut investment by 14% and employment by 2.3%.In order to evaluate the effectiveness of macroprudential regulation, we model an open-economy with a banking sector borrowing from domestic and in-ternational depositors. We show that, during a financial crises, in an economy with counter cyclical bank capital requirements(compared with an economy with constant capital requirements):(i) gross domestic product falls 5 p.p. less and (ii)the fall in investment is 3 p.p. lower. We show that imposing countercyclical capital requirements entails a trade-off between lower volatility and lower economic activity.Overall, we find that countercyclical bank capital requirements may not be welfare improving for the Portuguese economy.