Welfare analysis of bank capital requirements with endogenous default

Abstract

This paper presents a tractable framework with endogenous default and evaluates the welfare implication of bank capital requirements. We analyze the response of social welfare to a negative technology shock under different capital requirement regimes with and without default. We show that including default as an additional indicator of capital requirements is welfare improving. When implementing capital requirements, a more aggressive reaction to the default rate is more effective for weakening the negative effect of the shock on welfare. Compared with output gap, the credit-to-output gap is a better indicator for implementing the countercyclical capital buffer.JEL Classification: E44, E47, E58, G28

Macroprudential regulation as part of the Mexican policy toolkit

“…Therefore, the equilibrium for this model is a set of sequences for the quantities { , , , , , , , , , * , , ψ } =0 ∞ together with the sequence of prices { , , , , , , , * , } =0 ∞ and values { , , , , , } =0 ∞ such that satisfy equations (1) to (27) with the sequence of shocks { } =0 ∞ , given 0 , 0 , 0 , 0 , 0 * , 0 , 0 , 0 , 0 , 0 * , and 0 . In the absent of shocks, the model has a unique stationary equilibrium, all rigidities disappear, and the entrepreneurs hit the borrowing constraint.…”