The role of capital requirements and credit composition in the transmission of macroeconomic and financial shocks

Abstract

a b s t r a c tThis paper builds a general equilibrium model that incorporates a bank, borrowing constraints, default and an exogenous capital requirement to study the effect of the latter on the composition of bank funding and on the response of the economy to shocks. Ex-ante heterogeneous households decide how much to save or borrow for the sake of consumption (consumer credit) or the provision of housing services(mortgages). These choices are subject to borrowing limits, which depend on the value of real estate assets (for mortgages) or labour income (for consumer loans). The model includes a final good producer and a continuum of intermediate goods producers who must borrow in order to finance working capital/labour requirements (business credit borrowing) and are subject to nominal rigidities. Saving and borrowing are intermediated by a bank facing exogenous capital requirements that differ for each credit category. Capital requirements are modelled as a penalty function following Den Haan and De Wind (2012). The paper focuses on the response of the model economy to monetary, productivity and financial shocks with or without capital requirements. In the absence of capital requirements, any shock that reduces the deposit rate will incentivize the bank to switch away from bank capital into deposits, thus increasing the demand for deposits and dampening the effect of the shock on interest rates and the price of housing services. The main effect of capital requirements in the model is to disrupt the ability of the bank of switching to cheaper funding sources (deposits) after a shock. Capital requirements thus have the effect of amplifying the response of aggregate variables to shocks through the composition of the right-hand side of the balance-sheet of the bank, and not through the well-studied channel of leverage constraints affecting its left-hand side.

Movement of the components of Russian financial capital

“…Oscar Valencia, Daniel Osorio, Pablo Garay point out that without requirements to capital any shock reducing deposits interest rate would stimulate a bank to switch from bank capital to deposits thus increasing the demand for deposits and softening the shock effect on interest rates and mortgage loan prices. Requirements to capital amplify the reaction of aggregated variables to shocks at the cost of the right part of bank balance [19].…”