Procyclicality of Capital Requirements in a General Equilibrium Model of Liquidity Dependence

30 Pages Posted: 8 Oct 2009

See all articles by Francisco Covas

Francisco Covas

Board of Governors of the Federal Reserve System

Shigeru Fujita

Federal Reserve Bank of Philadelphia

Date Written: September 1, 2009

Abstract

This paper attempts to quantify business cycle effects of bank capital requirements. The authors use a general equilibrium model in which financing of capital goods production is subject to an agency problem. At the center of this problem is the interaction between entrepreneurs' moral hazard and liquidity provision by banks as analyzed by Holmstrom and Tirole (1998). They impose capital requirements on banks and calibrate the regulation using the Basel II risk-weight formula. Comparing business cycle properties of the model under this procyclical regulation with those under hypothetical countercyclical regulation, the authors find that output volatility is about 25 percent larger under procyclical regulation and that this volatility difference implies a 1.7 percent reduction of the household's welfare. Even with more conservative parameter choices, the volatility and welfare differences under the two regimes remain nonnegligible.

Keywords: Procyclicality, capital requirements, countercyclical regulation

JEL Classification: E32, G21, G28

Suggested Citation

Covas, Francisco and Fujita, Shigeru, Procyclicality of Capital Requirements in a General Equilibrium Model of Liquidity Dependence (September 1, 2009). FRB of Philadelphia Working Paper No. 09-23. Available at SSRN: https://ssrn.com/abstract=1485007 or http://dx.doi.org/10.2139/ssrn.1485007

Francisco Covas (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Shigeru Fujita

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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