Risk shocks, due loans, and policy options: When less is more!

We use a dynamic stochastic general equilibrium model endowed with a complex banking system—in which due loans, occasionally binding credit restrictions, a cost of borrowing channel, and regulatory (capital and impairment) requirements coexist—to analyze the performance of various policy options impacting impairment recognition by banks. We discuss how looser or tighter policy designs affect output and welfare—both in the steady state and alongside dynamics—and the main driving forces that lie beneath the effects. The holding cost of due loans, restrictions to credit, dividend strategy, and the cure rate are key components of the driveshaft propelling policies to outcomes. We find that looser policies outperform tighter ones only if reflected into higher capital buffers (extra income is retained and not distributed as dividends) and for sufficiently low values of the holding cost. Higher cure rates increase the effectiveness of looser policies—they dominate for a wider range of holding costs—by raising the benefits of delaying impairment recognition. A policy targeting impairment recognition seems to take the upper edge due to its combined steady-state and business-cycle effects, but a policy that allows the regulatory impairment recognition to respond to the cycle is more effective from a business-cycle stabilization standpoint. Occasionally binding credit restrictions boost the effectiveness of looser policies during recessions due to its asymmetric effects over the cycle, pushing the mean output upwards.