Working Paper: CEPR ID: DP14427
Authors: Caterina Mendicino; Kalin Nikolov; Juan Francisco Rubioramrez; Javier Suarez; Dominik Supera
Abstract: We examine optimal capital requirements in a quantitative general equilibrium model with banks exposed to non-diverfisiable borrower default risk. Contrary to standard models of bank default risk, our framework captures the limited upside but significant downside risk of loan portfolio returns (Nagel and Purnanandam, 2020). This helps to reproduce the frequency and severity of twin defaults: simultaneously high firm and bank failures. Hence, the optimal bank capital requirement, which trades off a lower frequency of twin defaults against restricting credit provision, is 5pp higher than under standard default risk models which underestimate the impact of borrower default on bank solvency.
Keywords: financial intermediation; macroprudential policy; default risk; bank assets; returns
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 |
|---|---|
| higher capital requirements (G28) | reduce the probability of twin defaults (G33) |
| underestimating borrower default impacts (G21) | lower optimal capital requirements (G32) |
| lower optimal capital requirements (G32) | increase the risk of twin defaults (G33) |
| reduce the probability of twin defaults (G33) | mitigate negative welfare impacts associated with bank insolvencies (F65) |
| optimal bank capital requirement is five percentage points higher than standard models predict (G21) | reflects increased frequency and severity of twin defaults (G33) |