The Optimal Response of Bank Capital Requirements to Credit and Risk in a Model with Financial Spillovers

58 Pages Posted: 4 Jul 2017

See all articles by Filippo Occhino

Filippo Occhino

Federal Reserve Banks - Federal Reserve Bank of Cleveland

Date Written: June 7, 2017

Abstract

This paper studies optimal bank capital requirements in an economy where bank losses have financial spillovers. The spillovers amplify the effects of shocks, making the banking system and the economy less stable. The spillovers increase with banks’ financial distortions, which in turn increase with banks’ credit risk. Higher capital requirements dampen the current supply of banks’ credit, but mitigate banks’ future financial distortions. Capital requirements should be raised in response to both an expansion of banks’ credit supply and an increase in the expected future credit risk of banks. They should be lowered close to one-to-one in response to bank losses.

Keywords: Debt Overhang, Financial Vulnerabilities, Financial Stability

JEL Classification: G20, G28

Suggested Citation

Occhino, Filippo, The Optimal Response of Bank Capital Requirements to Credit and Risk in a Model with Financial Spillovers (June 7, 2017). FRB of Cleveland Working Paper No. 17-11. Available at SSRN: https://ssrn.com/abstract=2995718

Filippo Occhino (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Cleveland ( email )

East 6th & Superior
Cleveland, OH 44101-1387
United States

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