The recent global financial crisis has revealed the limits of standing macroeconomic policy frameworks that rely on monetary and fiscal policies alone. These policies moderated business cycles and kept inflation low and stable, but they were unable to prevent a massive build-up of systemic financial risk and, ultimately, a deep and prolonged global recession (Blanchard and others, 2010).
To address the shortcomings of current macroeconomic frameworks, an increasingly widespread “macro prudential” view holds that prudential financial regulations should be used as counter-cyclical policy instruments (Borio and others, 2001; Borio, 2003; Kashyap and Stein, 2004). Specifically, prudential regulations should be loosened during recessions and tightened during expansions to limit systemic financial risk and dampen credit and output swings.
One main argument that supports the counter-cyclical use of bank capital requirements goes as follows. During recessions, loan defaults cause bank capital write-offs that, in turn, force banks to raise new capital or withdraw maturing loans and accumulate cash assets in order to satisfy the required risk-weighted asset ratio. As raising new capital is typically difficult in bad times, banks tend to satisfy the requirement through loan supply reductions, which amplify the credit crunches and the recessions. These amplification effects can be avoided by lowering the capital requirements at the beginning of recessions. Similarly, during upswing phases of business cycles, credit booms and pro-cyclicality could be contained by tightening bank capital requirements.
Though appealing, this argument overlooks the fact that the banking system’s lending capacity is determined, to a large extent, by the households’ willingness to provide savings in the form of bank deposits and equity holdings. The literature is missing a general equilibrium framework that accounts for the effects of capital requirement policies on the consumption-saving decisions of households and, through this channel, on credit and output. In this paper, we provide such a framework and address the following question: how should bank capital requirements be set in different phases of the business cycle?In particular, should bank capital requirements be tightened during expansions and loosened during recessions, as the growing “macro prudential” literature suggests?
This paper shows that a policy that tightens bank capital requirements in anticipation of future recessions and loosens such requirements at the onset of recessions is optimal. It also shows, however, that this policy can exacerbate lending and output booms prior to recessions. Thus, such a policy would not serve the macro-prudential purpose of leaning against the expansionary phase of the business cycle, as conventional views hold. The reason is that households and the whole economy must boost savings during the economic expansion in order to build up counter-cyclical bank capital buffers. Higher savings, in turn, exacerbate credit and output booms.
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On the Optimality of Bank Capital Requirement Policy in a Macroeconomic Framework
