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Capital Requirements and Monetary Policy

Paper Session

Saturday, Jan. 5, 2019 2:30 PM - 4:30 PM

Atlanta Marriott Marquis, International B
Hosted By: American Economic Association
  • Chair: Bruno Sultanum, Federal Reserve Bank of Richmond

Banking Industry Dynamics and Size-Dependent Capital Regulation

Tirupam Goel
Bank for International Settlements


This paper develops a model of a dynamic and heterogeneous banking sector,
embedded in a general equilibrium framework. The objective is two-fold. The first is
to offer a model of the banking industry where leverage is a driver of the dynamics,
and where the implied distribution of bank capital closely matches the one that
observed in data. The second objective is to characterize the optimal size-dependent
capital regulation. The rationale for regulation arises because deposit insurance
induces banks to assume more leverage – defined as the ratio of assets to capital – than
what is socially optimal. As such, a limit on leverage improves welfare. Crucially,
the optimal regulation is size-specific – it tighter for larger banks. Intuitively, this
is for three reasons. First, allowing small banks to assume more leverage enables
them to grow faster, leading to a growth effect. Second, although more leverage by
small banks results in a higher failure rate among them, the failing banks are the less
productive ones, leading to a cleansing effect. Third, relative to small banks, large
banks entail more correlated shocks per unit asset, and are therefore, riskier. As
such, tighter regulation for large banks lowers the overall riskiness of banks’ assets,
leading to a stabilization effect. The model provides support for policies – such as the
GSIB framework – that impose tighter regulation on large and systemically important

How Do Capital Requirements Affect Loan Rates? Evidence from High Volatility Commercial Real Estate

Robert Kurtzman
Federal Reserve Board
David Glancy
Federal Reserve Board


We study how bank loan rates responded to a 50% increase in capital requirements for a subcategory of construction lending, High Volatility Commercial Real Estate (HVCRE). To identify this effect, we exploit variation in the loan terms determining whether a loan is classified as HVCRE and the time that a treated loan would be subject to the increased capital requirements. We estimate that the HVCRE rule increases loan rates by about 40 basis points for HVCRE loans, indicating that a one percentage point increase in required capital raises loan rates by about 9.5 basis points.

Modeling Your Stress Away

Friederike Niepmann
Federal Reserve Board
Viktors Stebunovs
Federal Reserve Board


We investigate systematic changes in banks’ projected credit losses between the 2014 and 2016 EBA stress tests, employing methodology from Philippon et al. (2017). We find that projected credit losses were smoothed across the tests through systematic model adjustments. Those banks whose losses would have increased the most from 2014 to 2016 due to changes in the supervisory scenarios—keeping the models constant and controlling for changes in the riskiness of underlying portfolios—saw the largest decrease in losses due to model changes. Model changes were realistic and more pronounced for banks that rely more on the Internal Ratings-Based
approach, and they explain the cross-section of market responses to the release of the 2016
results. Stock prices and CDS spreads increased more for banks with larger reductions
in projected credit losses due to model changes, as investors apparently did not interpret
lower loan losses as reflecting mainly a decrease in credit risk but, instead, as a sign of lower
capital requirements going forward.

Financial Intermediation through Financial Disintermediation: Evidence from the ECB Corporate Sector Purchase Programme

Aytekin Ertan
London Business School
Anya Kleymenova
University of Chicago
Marcel Tuijn
University of Chicago and Erasmus University


We study the spillover effects of financial disintermediation in the corporate sector on the supply of credit to small and medium enterprises (SMEs). We find that direct central bank lending to large corporations induces banks to increase lending to SMEs by 10 percent and that this effect is stronger for liquidity-constrained banks. SMEs are also more likely to forge new banking relationships and access credit more cheaply. Finally, SMEs seem to use the additional credit for investment and hiring purposes. We verify that these inferences are not due to changing economic fundamentals or selection effects in central bank financing.

Countercyclical Bank Liquidity, Procyclical Capital and Their Interactions in an Equilibrium Analysis

Chao Huang
University of Edinburgh
Fernando Moreira
University of Edinburgh
Thomas Archibald
University of Edinburgh


This paper studies the impact of regulatory requirements on banks’ capital and liquidity holdings in booms and recessions. We contribute to the literature by building a novel dynamic model whose equilibrium is achieved when banks optimally choose liquidity holdings under the steady state capital holding ratio. It considers two liquidity management strategies that allows banks to adjust liquid assets and illiquid liabilities to cope with liquidity shocks. Failure to accomplish so will result in a fire sale of illiquid assets which will heavily reduce banks’ market value. We have compared banks’ optimal capital (and liquidity) structure choice under different regulation regimes, and have found a significant effect of capital holdings on banks’ liquidity holding behaviour. Generally, an existing high capital ratio will discourage banks from retaining sufficient liquidity. However, if the overall economic situation deteriorates, an excess liquidity buffer is possible which will make banks immune from liquidity shocks but will lead to an insignificant impact of capital on liquidity hoardings. The resulting choice of liquidity is undesirably low in booms causing an excessively high probability of default. Capital and liquidity requirements are both necessary for banking regulation and an effective liquidity requirement is more desirable when a stringent capital requirement is present, such as Basel III, which is more likely to discourage banks from holding liquidity. As for social welfare, Basel III is the best regulatory regime among the rules considered, which supports the adoption of this newly established regulation. We also find an inverted U-shaped relationship between social welfare and liquidity requirements, indicating the existence of an optimal level of liquidity requirement.
JEL Classifications
  • G2 - Financial Institutions and Services