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Discussion Paper Details

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Title: Optimal capital requirements over the business and financial cycles

Author(s): Fr�d�ric Malherbe

Publication Date: February 2015

Keyword(s): Basel 3, capital requirement, costly default, counter-cyclical buffers, financial cycles and financial regulation

Programme Area(s): Financial Economics and International Macroeconomics

Abstract: I propose a simple theory of intertwined business and financial cycles, where financial regulation both optimally responds to and influences the cycles. In this model, banks do not internalize the effect of their credit expansion on other banks? expected bankruptcy costs, which leads to excessive aggregate lending. In response, the regulator sets a capital requirement to trade off expected output against financial stability. The capital requirement that ensures investment efficiency depends on the state of the economy and, because of a general equilibrium effect, its stringency increases with aggregate banking capital. A regulation that fails to take this effect into account would exacerbate economic fluctuations and result in excessive aggregate lending during a boom. It would also allow for an excessive build-up of risk in the financial sector, which implies that, at the peak of a boom, even a small adverse shock could trigger a banking sector collapse, followed by an excessively severe credit crunch.

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Bibliographic Reference

Malherbe, F. 2015. 'Optimal capital requirements over the business and financial cycles'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10387