Dynamic Macro-Prudential Regulation
26 Pages Posted: 15 Mar 2012 Last revised: 17 Dec 2012
Date Written: December 17, 2012
I propose a model in which government guarantees induce excessive aggregate lending by the financial sector. In response, the regulator sets macro-prudential capital requirements to trade-off growth (expected output) with financial stability (lower probability and social cost of a banking sector collapse). This trade-off depends on the state of the economy and optimal capital requirements are therefore not constant. I first establish in a risk-neutral benchmark that the optimal macro-prudential capital requirements are higher in good times if the long-run productivity-elasticity of aggregate banking capital is larger than that of the optimal stock of physical capital. Then, I show that this condition is always satisfied in a simple OLG model with a neoclassical production function. The transition dynamics of optimal requirement, however, depend on the difference in the short-run productivity-elasticities, which can go either way. Risk aversion affects the level of optimal requirements, but only extreme cyclical variations of effective risk aversion would substantially modify their cyclical properties.
Finally, I compare the optimal policy to the (best possible) constant capital requirement and show that the latter not only generates excess volatility but also episodes of extreme over-lending. In such cases, there is no longer a trade-off: an increase in capital requirement would both be good for growth and improve financial stability.
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