Optimal Dynamic Capital Requirements and Implementable Capital Buffer Rules

44 Pages Posted: 21 Aug 2020 Last revised: 25 Apr 2022

See all articles by Matthew B. Canzoneri

Matthew B. Canzoneri

Georgetown University

Behzad Diba

Georgetown University - Department of Economics

Luca Guerrieri

Board of Governors of the Federal Reserve System

Arsenii Mishin

National Research University Higher School of Economics - Faculty of Economics; National Research University Higher School of Economics - Faculty of Economics

Date Written: August, 2020

Abstract

We build a quantitatively relevant macroeconomic model with endogenous risk-taking. In our model, deposit insurance and limited liability can lead banks to make risky loans that are socially inefficient. This excessive risk-taking can be triggered by aggregate or sectoral shocks that reduce the return on safer loans. Excessive risk-taking can be avoided by raising bank capital requirements, but unnecessarily tight requirements lower welfare by limiting liquidity producing bank deposits. Consequently, optimal capital requirements are dynamic (or state contingent). We provide examples in which a Ramsey planner would raise capital requirements: (1) during a downturn caused by a TFP shock; (2) during an expansion caused by an investment-specific shock; and (3) during an increase in market volatility that has little effect on the business cycle. In practice, the economy is driven by a constellation of shocks, and the Ramsey policy is probably beyond the policymaker's ken; so, we also consider implementable policy rules. Some rules can mimic the optimal policy rather well but are not robust to all the calibrations we consider. Basel III guidance calls for increasing capital requirements when the credit to GDP ratio rises, and relaxing them when it falls; this rule does not perform well. In fact, slightly elevated static capital requirements generally do about as well as any implementable rule.

Keywords: counter-cyclical capital buffer, DSGE models, Bank capital requirements, Ramsey policy

JEL Classification: C51, E58, G28

Suggested Citation

Canzoneri, Matthew B. and Diba, Behzad and Guerrieri, Luca and Mishin, Arsenii, Optimal Dynamic Capital Requirements and Implementable Capital Buffer Rules (August, 2020). FEDS Working Paper No. 2020-56, Available at SSRN: https://ssrn.com/abstract=3678340 or http://dx.doi.org/10.17016/FEDS.2020.056

Matthew B. Canzoneri (Contact Author)

Georgetown University ( email )

Washington, DC 20057
United States

Behzad Diba

Georgetown University - Department of Economics ( email )

Washington, DC 20057
United States

Luca Guerrieri

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2550 (Phone)

Arsenii Mishin

National Research University Higher School of Economics - Faculty of Economics ( email )

Shabolovka 26
Moscow, 119049
Russia

National Research University Higher School of Economics - Faculty of Economics ( email )

Shabolovka 26
Moscow, 119049
Russia

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