Optimal Capital Requirements over the Business and Financial Cycles
- American Economic Journal: Macroeconomics (Forthcoming)
I study economies where banks do not fully internalize the social costs
of their lending decisions, which leads to real over-investment. The bank
capital requirement that restores investment efficiency varies over time.
During booms, more investment is desirable, so the banking sector must
be allowed to expand. This suggests a loosening of the requirement. However,
there also is more bank capital. Since the banking sector exhibits
decreasing returns to scale, this suggests a tightening instead. I find that
the latter effect, which I dub the bank capital channel, dominates: The
optimal capital requirement is tighter during booms than in recessions.
Forthcoming Article Downloads