There has been a strong interest in understanding interactions between bank capital regulation and macroeconomic fluctuations among policy makers and academic researchers. The interest has become even stronger in the aftermath of the recent financial crisis. One of the key concerns, especially from a macroeconomic perspective, is that bank capital regulation can induce significant “procyclicality,” meaning that bank capital regulation can amplify the macroeconomic fluctuations. The procyclical effect was recognized under the first bank capital regulation, i.e., Basel I, in which banks are required to hold a constant fraction of equity. The procyclicality issue has received significantly more attention under the so-called risk-sensitive regulation (Basel II). Under Basel II, the risk weight associated with each loan is negatively related to the borrower’s credit quality; therefore, during an economic down-turn when overall credit quality deteriorates, capital requirements become more stringent. This further limits banks’ lending capacity. Our interest is to quantify the procyclical effects using a general equilibrium macroeconomic model.
There are many papers with similar interests. Blum and Hellwig (1995) examine the procyclical effects of fixed capital requirements under Basel I. Using a simple reduced-form macroeconomic framework, they argue that it is likely to amplify macroeconomic fluctuations. Heid (2007) goes one step further by studying the implications of risk-sensitive capital requirements in a similar reduced-form environment. More recently, Zhu (2008) studies the effects of bank capital regulation on banks’ behavior by applying the industry model of Cooley and Quadrini (2001) to a banking sector that is subject to risk-sensitive capital requirements. Finally, Repullo and Suarez (2009) develop a micro-founded partial equilibrium model of relationship banking and analyze the banks’ behavior under risk-sensitive capital requirements. They show that the procyclicality under Basel II can be sizable.
Relative to these previous studies, we examine the business cycle implications of bank capital requirements in a general equilibrium macroeconomic model. Using a general equilibrium framework allows us to quantify the impact of bank capital regulation on macroeconomic variables. In our model, the financing of capital goods production is subject to an agency problem, as in Carlstrom and Fuerst (1997). The financing problem, however, is characterized by entrepreneurs’ moral hazard and liquidity provision by financial intermediaries. This framework is proposed by Holmstrom and Tirole (1998) and adapted by Kato (2006) to a DSGE environment. We extend Kato’s work along several dimensions so that we can examine the quantitative impact of bank capital regulation. We are aware that there are several alternative approaches. The first alternative would be the costly state verification framework developed by Townsend (1979) and popularized in macroeconomics by Bernanke and Gertler (1989), Carlstrom and Fuerst (1997), and Bernanke et al. (1999). The second alternative is the double moral hazard framework of Holmstrom and Tirole (1997) that is adapted to the macroeconomic environment by Chen (2001) and Meh and Moran (2010). We have adopted the framework of Holmstrom and Tirole (1998), because the model generates countercyclical liquidity dependence; firms tend to rely more heavily on lines of credit to finance their liquidity needs during downturns; and this countercyclical liquidity dependence underscores the important role banks play in an economy. The importance of credit lines in bank financing is very well known. For instance, loans made under a credit line amount to almost 80% of total C&I loans. As Schuermann (2009) mentions, during economic downturns, market finance becomes scarce, and firms increase their liquidity dependence on banks by drawing down the loan commitments prearranged with banks. These empirical observations have led us to use the liquidity dependence framework instead of other popular frameworks mentioned above. This paper attempts to quantify the interaction between liquidity dependence and bank capital regulation.
We impose bank capital requirements assuming that raising funds through equity is more costly than through deposits, as in Repullo and Suarez (2009). We assume that the capital requirement ratio increases inversely with the business cycle under Basel II while it is fixed at a prespecified level of 8% under Basel I. Another key ingredient of our paper is the assumption that equity issuance is more costly in recessions. It is well known that new equity issuance during a downturn can be very costly.4 More generally speaking, as noted by Kashyap and Stein (2004), bank equity becomes scarcer in downturns, raising its (shadow) cost. By introducing the time-varying equity issuance cost, we distinguish between the two regulatory regimes depending on whether only the equity issuance cost is time varying (Basel I) or both the equity issuance cost and the capital requirement ratio are time varying (Basel II). Adopting these parsimonious specifications allows us to assess the procyclicality effects in a stylized DSGE environment.
The model is calibrated by using relevant observable information such as the utilization rate of credit lines. We specify the time-varying capital requirement in our model by using the actual Basel II risk-weight formula. To calibrate the equity issuance cost variable, we utilize the evidence by Kashyap and Stein (2004) that the additional cyclical pressure on bank capital positions under Basel II is of almost the same order of magnitude as the effect under Basel I. Further, we also consider cases in which the equity issuance cost responds more sharply to the business cycles. This is motivated by Repullo and Suarez (2009)’s claim that the shadow cost of bank equity can be very high at the time of financial distress. It is shown that, across various plausible calibrations, Basel I and Basel II contribute to increasing the standard deviation of output fluctuations by around 5 basis points and 10 basis points, respectively. We argue that these “average” effects hide important differences in the paths of aggregate output which occur around business-cycle peaks and troughs. For example, around the bottom of business cycles, output in the Basel I economy can be lower than that in the no-requirement economy by 10-15 basis points. This magnification effect can be as large as 20-40 basis points when the Basel II economy is compared with the no-requirement economy.
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Procyclicality of Capital Requirements in a General Equilibrium Model of Liquidity Dependence
