Anti-Cyclical Bank Capital Regulation and Monetary Policy

The financial crisis of 2008/09 revived attention given to credit booms and busts and bank credit pro-cyclicality. The regulation guidelines of Basel III attempt to improve the quality of bank capital and explicitly includes a capital buffer to address cyclicality. In this paper we study the interaction between cyclical capital rules and alternative types of monetary policy in the context of a dynamic stochastic general equilibrium model. We find that: First, capital requirements amplify the effects of various exogenous shocks. Second, anti-cyclical requirements (as in Basel III) indeed, and as intended by the regulation, have important stabilization properties relative to the case of constant requirements (as in Basel I). This is true for all types of fluctuations that we study, which include those caused by productivity, demand-side, preference and monetary shocks. The quantitative results are sensitive to the size of the capital buffer (over minimum requirements) optimally held by banks. In particular, with reasonably large buffers, the economy behaves just as when there is no regulation, in which case a very strongly cyclical capital rule would be required to have significant effects.