The Procyclical Effects of Bank Capital Regulation
CentER Discussion Paper Series No. 2010-29S
51 Pages Posted: 18 Mar 2010
Date Written: October 31, 2009
We assess the procyclical effects of bank capital regulation in a dynamic equilibrium model of relationship lending in which banks are unable to access the equity markets every period. Banks anticipate that shocks to their earnings as well as the cyclical position of the economy can impair their capacity to lend in the future and, as a precaution, hold capital buffers. We find that under cyclically-varying risk-based capital requirements (e.g. Basel II) banks hold larger buffers in expansions than in recessions. Yet, these buffers are insufficient to prevent a significant contraction in the supply of credit at the arrival of a recession. We show that cyclical adjustments in the confidence level underlying Basel II can reduce its procyclical effects on the supply of credit without compromising banks’ long-run solvency targets.
Keywords: Banking regulation, Basel II, Business cycles, Capital requirements, Credit crunch, Loan defaults, Relationship banking
JEL Classification: G21, G28, E44
Suggested Citation: Suggested Citation