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Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model

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  • Juliane Begenau

    (Harvard Business School)

Abstract

This paper presents a quantitative dynamic general equilibrium model in which households' liquidity preference change the standard intuition of how higher bank capital requirements affect the economy. The mechanism is that a reduction in the supply of safe and liquid assets in the form of bank debt increases bank lending through a general equilibrium effect. I embed this mechanism in a two-sector business cycle model in which banks provide liquidity and have excessive risk-taking incentives. I quantify this model using data from the National Income and Product Accounts and banks' regulatory filings. Welfare is maximized at 14% equity as a share of risk-weighted assets. This level of capital requirement trades-off a reduction in the provision of safe and liquid assets against an increase in lending and a reduction in risk-taking by banks.

Suggested Citation

  • Juliane Begenau, 2015. "Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model," 2015 Meeting Papers 687, Society for Economic Dynamics.
    • Handle: RePEc:red:sed015:687
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