Banking Dynamics and Capital Regulations

This paper proposes a quantitative model of the banking sector to analyze potential aggregate impacts of the minimum capital requirements and counter-cyclical capital buffer in Basel III capital regulations. In the literature, an analysis on aggregate impacts of counter-cyclical capital buffer is limited. In order to fill this gap, the paper augments a standard banking model in two ways: (i) allows banks to default due to un-diversifiable risk based on the assumption of incomplete markets with respect to credit risk of bank loans and (ii) incorporates market-based funding with its equilibrium price reflecting individual-bank specific default premium. A numerical analysis of the model suggests that counter-cyclical capital buffer smoothes aggregate loan dynamics over time but its quantitative implication is limited during recessions. A larger quantitative impact can be obtained if the regulation allows the captail requiremnt to be lower also during recovery periods. Such state-contingent policies can raise bank default rates, posing a potential trade-off. ∗University of Pennsylvania, CAERP, and NBER, vr0j@upenn.edu. †Bank of Canada, takt@bankofcanada.ca. ‡Bank of Canada, yterajima@bankofcanada.ca.