The Gilded Bubble Buffer
40 Pages Posted: 12 Nov 2017
Date Written: October 19, 2017
Excessive credit growth and high asset prices increase systemic risks. Because, in equilibrium, these two variables are jointly determined the analysis of systemic risk and the cost-benefit analysis of macroprudential regulation require a specific framework consistent with the existing empirical evidence. We argue that an overlapping generation model of rational bubbles can explain some of the main features of banking crises, thus providing a microfounded framework for the rigorous analysis of macroprudential policy. We find that credit financed bubbles may have a role as a buffer in channeling excessive credit supply and inefficient investment at the firms’ level. Still, when banks have a risk of going bankrupt a trade-off appears between financial stability and efficiency. When this is the case, macroprudential policy has a key role in improving efficiency while preserving financial stability. Contrarily to common regulatory views, the one size fits all approach where a countercyclical buffer is implemented to counteract an excessive increase in credit growth, the optimal macroprudential policy has to take into account the origin of the shock. As wages, liquidity and productivity shocks determine the equilibrium level of credit, it is not surprising that the optimal macroprudential policy has to adapt to each type of shock.
Keywords: Banks, Bubbles, Macroprudential Regulation
JEL Classification: E44, E60, G18, G21, G28
Suggested Citation: Suggested Citation