Financial Capital and the Macroeconomy: Policy Considerations
41 Pages Posted: 20 May 2011
Date Written: May 5, 2011
Abstract
We develop a macroeconomic model in which the balance sheet/liquidity condition of financial institutions plays an important role in the determination of asset prices and economic activity. The financial intermediaries in our model are required to make investment commitments before a complete resolution of idiosyncratic funding risk that can be addressed only by costly refinancing, forcing them to behave in a risk-averse manner. The model shows that the balance sheet condition of intermediaries can drive asset values away from their fundamentals, causing aggregate investment and output to respond to shocks to intermediaries. We use this model to evaluate several public policies designed to address balance sheet problems at financial institutions. With regard to short-run policies, we find that capital injections conditioned upon voluntary recapitalization can be a more effective tool than direct lending/asset purchases. With regard to long-run policies, we demonstrate that higher capital requirements can have sizable short-run effects on economic activity if not implemented carefully, and that a long transition period helps avoid such effects.
Keywords: Capital market friction, financial intermediary, capital constraint, Liquidity based asset pricing, asset purchase program, capital injection policy, regulatory capital standards
JEL Classification: E32, E44, E63
Suggested Citation: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
Mitigating the Procyclicality of Basel II
By Rafael Repullo, Jesus Saurina Salas, ...
-
Mitigating the Pro-Cyclicality of Basel II
By Rafael Repullo, Jesus Saurina Salas, ...
-
Financial Sector Pro-Cyclicality: Lessons from the Crisis
By Fabio Panetta, Paolo Angelini, ...
-
The Effects of Bank Capital on Lending: What Do We Know, and What Does It Mean?
-
The Effects of Bank Capital on Lending: What Do We Know, and What Does it Mean?
-
The Procyclical Effects of Bank Capital Regulation
By Rafael Repullo and Javier Suarez
-
The Procyclical Effects of Bank Capital Regulation
By Rafael Repullo and Javier Suarez
-
The Countercyclical Capital Buffer of Basel III: A Critical Assessment
-
Earnings and Capital Management in Alternative Loan Loss Provision Regulatory Regimes
By Jesus Saurina Salas, Daniel Perez, ...