Aggregate Investment Externalities and Macroprudential Regulation

44 Pages Posted: 20 Jan 2012

See all articles by Hans Gersbach

Hans Gersbach

ETH Zurich - CER-ETH -Center of Economic Reseaarch; IZA Institute of Labor Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Jean-Charles Rochet

GFRI, University of Geneva; Swiss Finance Institute; University of Zurich - Swiss Banking Institute (ISB)

Multiple version iconThere are 2 versions of this paper

Date Written: January 2012

Abstract

Evidence suggests that banks tend to lend a lot during booms, and very little during recessions. We propose a simple explanation for this phenomenon. We show that, instead of dampening productivity shocks, the banking sector tends to exacerbate them, leading to excessive fluctuations of credit, output and asset prices. Our explanation relies on three ingredients that are characteristic of modern banks' activities. The first ingredient is moral hazard: banks are supposed to monitor the small and medium sized enterprises that borrow from them, but they may shirk on their monitoring activities, unless they are given sufficient informational rents. These rents limit the amount that investors are ready to lend them, to a multiple of the banks' own capital.

The second ingredient is the banks' high exposure to aggregate shocks: banks' assets have positively correlated returns. Finally the third ingredient is the ease with which modern banks can reallocate capital between different lines of business. At the competitive equilibrium, banks offer privately optimal contracts to their investors but these contracts are not socially optimal: banks' decisions of reallocating capital react too strongly to aggregate shocks. This is because banks do not internalize the impact of their decisions on asset prices. This generates excessive fluctuations of credit, output and asset prices. We examine the efficacy of several possible policy responses to these properties of credit markets, and derive a rationale for macroprudential regulation.

Keywords: Bank Credit Fluctuations, Investment Externalities, Macroprudential Regulation

JEL Classification: D86, G21, G28

Suggested Citation

Gersbach, Hans and Rochet, Jean-Charles, Aggregate Investment Externalities and Macroprudential Regulation (January 2012). CEPR Discussion Paper No. DP8764. Available at SSRN: https://ssrn.com/abstract=1988695

Hans Gersbach (Contact Author)

ETH Zurich - CER-ETH -Center of Economic Reseaarch ( email )

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Zurich, 8092
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+41 44 632 82 80 (Phone)
+41 44 632 18 30 (Fax)

IZA Institute of Labor Economics

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Germany

CESifo (Center for Economic Studies and Ifo Institute)

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Germany

Centre for Economic Policy Research (CEPR)

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United Kingdom

Jean-Charles Rochet

GFRI, University of Geneva ( email )

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Genève, CH - 1205
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneve
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1211 Geneva, CH-6900
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University of Zurich - Swiss Banking Institute (ISB) ( email )

Plattenstrasse 14
CH-8032 Zurich, Zurich 8032
Switzerland

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