December 2010 issue contents
Procyclicality of Capital Requirements in a General Equilibrium Model of Liquidity Dependence

by Francisco Covasa and Shigeru Fujitab


This paper quantifies the procyclical effects of bank capital requirements in a general equilibrium model where financing of capital goods production is subject to an agency problem. At the center of this problem is the interaction between entrepreneurs' moral hazard and liquidity provision by banks as analyzed by Holmstrom and Tirole (1998). We impose capital requirements under the assumption that raising funds through bank equity is more costly than raising it through deposits. We consider the time-varying capital requirement (as in Basel II) as well as the constant requirement (as in Basel I). Importantly, under both regimes, the cost of issuing equity is higher during downturns. Comparing output fluctuations under the Basel I and Basel II economies with those in the no-requirement economy, we find that the regulations have relatively minor average effects on output fluctuations (measured by the differences in the standard deviations). However, the effects are more pronounced around business cycle peaks and troughs.

JEL Codes: E42, E44, F31.

Full article (PDF, 37 pages 524 kb)

Discussion by Javier Suarez

a Division of Monetary Affairs, Board of Governors of the Federal Reserve System
b Research Department, Federal Reserve Bank of Philadelphia