09 July 2015

ECB: Capital regulation in a macroeconomic model with three layers of default

The basic model incorporates optimizing financial intermediaries who allocate their scarce wealth (inside equity) together with funds raised from saving households across two lending activities, mortgage lending to borrowing households and corporate lending to borrowing firms.

The external financing for all borrowers (including banks) takes the form of not contingent debt which is subject to default risk due to borrowers' exposure to both idiosyncratic and aggregate risk factors. Defaults are assumed to cause deadweight losses as in the costly state verification setup of Gale and Hellwig (1985). Households' and firms' leverage is an endogenous multiple of their net worth. In contrast, banks, which are assumed to obtain their outside funding in the form of government-guaranteed deposits, have their leverage limited by a regulatory capital requirement. Importantly, in spite of the presence of deposit insurance, we assume depositors to suffer some transaction costs if their banks fail. This generates a risk premium that acts as an important source of amplification when bank solvency is weak.

The model exhibits the operation of three interconnected net worth channels, which create the potential for amplification and propagation noted in various strands of the existing literature (including the one operating through the price of housing, which is the collateral used by the borrowing households), as well as distortions due to deposit insurance. While limited net worth typically leads to under-investment, the risk subsidization linked to deposit insurance creates the potential for an excessive supply of bank credit. The basic model is then suitable for a non-trivial welfare analysis of various forms of capital requirements imposed on banks' lending activities, which are at the core of macroprudential policy.

The normative results of the project rely on an explicit welfare analysis. Authors’ results document that there are large gains from rising capital requirements when bank risk of failure is significant. Further, bank-related amplification channels are strong and capital requirements are effective in shutting them down. In particular under the optimal capital requirements the economy mimics the behaviour of a no bank default economy. Countercyclical adjustments mitigate the impact of shocks with high capital requirements (or low bank risk), but are otherwise counterproductive.

Authors use the basic model developed in this paper to analyse the effects of capital requirements on steady state and on the transmission of various types of shocks. But the basic model can be extended to allow for the possibility of securitization and liquidity risk (e.g. in the form of interim funding shocks suffered by banks). These extensions may allow expanding the analysis to the regulatory treatment of securitization, liquidity regulation, and the assessment of lending of last resort policies. While the basic model belongs to the class of non-monetary models, introducing nominal rigidities and a meaningful role for monetary policy constitutes a natural third possible extension that would allow us to assess the interactions between macroprudential policy and monetary policy.

Full working paper

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