Working Paper: CEPR ID: DP13152
Authors: Caterina Mendicino; Kalin Nikolov; Javier Suarez; Dominik Supera
Abstract: How far should capital requirements be raised in order to ensure a strong and resilient banking system without imposing undue costs on the real economy? Capital requirement increases make banks safer and are beneficial in the long run but carry transition costs because their imposition reduces aggregate demand on impact. Under accommodative monetary policy, increasing capital requirements addresses financial stability risks without imposing large transition costs on the economy. In contrast, when the policy rate hits the lower bound, monetary policy loses the ability to dampen the effects of the capital requirement increase on the real economy. The long-run benefits of higher capital requirements are larger and the transition costs are smaller when the risk that causes bank failure is high.
Keywords: macroeconomic policy; bank fragility; financial frictions; default risk; effective lower bound; transition dynamics
JEL Codes: E3; E44; G01; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increasing capital requirements (G28) | Enhancing bank safety and resilience (G28) |
| Increasing capital requirements (G28) | Reducing aggregate demand on impact (E19) |
| Increasing capital requirements (with accommodative monetary policy) (E52) | Mitigating financial stability risks (F65) |
| Transition costs from increasing capital requirements (G28) | Reducing aggregate demand initially (E19) |
| Higher capital requirements (G28) | Long-run benefits for financial stability (E44) |
| Higher bank risks (G21) | Larger welfare gains from higher capital requirements (D69) |
| Transition to tighter capital requirements (G28) | Short-term output costs due to reduced credit availability (E51) |
| Gradual implementation of capital requirements + Accommodative monetary policy (E52) | Mitigating short-term output costs (D24) |
| Optimal increase in capital requirements (G28) | Context-dependent influence (D91) |