BUBBLES, CRASHES, AND THE FINANCIAL CYCLE: THE IMPACT OF BANKING REGULATION ON DEEP RECESSIONS

Sander van der Hoog · Herbert Dawid

38 citations0/0 files storedMacroeconomic Dynamics

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Banking stability, regulation, efficiency Monetary Policy and Economic Impact Economic theories and models

Abstract

This paper explores how different credit market and banking regulations affect business fluctuations. Capital adequacy- and reserve requirements are analyzed for their effect on the risk of severe downturns. We develop an agent-based macroeconomic model in which financial contagion is transmitted through balance sheets in an endogenous firm-bank network, which incorporates firm bankruptcy and heterogeneity among banks to capture the fact that contagion effects are bank specific. Using concepts from the empirical literature to identify amplitude and duration of recessions and expansions, we show that more stringent liquidity regulations are best to dampen output fluctuations and prevent severe downturns. Under such regulations, both leverage along expansions and amplitude of recessions become smaller. More stringent capital requirements induce larger output fluctuations and lead to deeper, more fragile recessions. This indicates that the capital adequacy requirement is procyclical and therefore not advisable as a measure to prevent financial contagion.

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References

1995Inside the Black Box: The Credit Channel of Monetary Policy Transmission 1987Stabilizing an Unstable Economy 1979Manias, Panics, and Crashes: A History of Financial Crises 2012Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870–2008 1991Saving and Liquidity Constraints 2008Zombie Lending and Depressed Restructuring in Japan 2002Dissecting the cycle: a methodological investigation 1988Credit, Money, and Aggregate Demand

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