Aggregate Investment Externalities and Macroprudential Regulation

44 Pages Posted: 6 Feb 2012

See all articles by Hans Gersbach

Hans Gersbach

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

Jean-Charles Rochet

University of Toulouse Capitole - Toulouse School of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: January 27, 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 show that it can provide a rationale for macroprudential regulation.

Keywords: Bank Credit Fluctuations, Macroprudential Regulation, Investment Externalities

JEL Classification: G21, G28, D86

Suggested Citation

Gersbach, Hans and Rochet, Jean-Charles, Aggregate Investment Externalities and Macroprudential Regulation (January 27, 2012). Swiss Finance Institute Research Paper No. 12-03, Available at SSRN: https://ssrn.com/abstract=1992989 or http://dx.doi.org/10.2139/ssrn.1992989

Hans Gersbach

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

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

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Jean-Charles Rochet (Contact Author)

University of Toulouse Capitole - Toulouse School of Economics ( email )

Toulouse
France

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