Discussion Paper Details

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Title: Capital Regulation and Credit Fluctuations

Author(s): Hans Gersbach and Jean-Charles Rochet

Publication Date: August 2012

Keyword(s): Complete Markets, Credit Fluctuations, Macroprudential Regulation and Misallocation of Borrowing Capacity

Programme Area(s): Financial Economics and International Macroeconomics

Abstract: We provide a rationale for imposing counter-cyclical capital ratios on banks. In our simple model, bankers cannot pledge the entire future revenues to investors, which limits borrowing in good and bad times. Complete markets do not sufficiently stabilize credit fluctuations, as banks allocate too much borrowing capacity to good states and too little to bad states. As a consequence, bank credit, output, capital prices or wages are excessively volatile. Imposing a (stricter) capital ratio in good states corrects the misallocation of the borrowing capacity, increases expected output and can be beneficial to all agents in the economy. Although in our economy, all agents are risk-neutral, counter-cyclical capital ratios are an effective stabilization tool. To ensure this effectiveness, capital ratios have to be based on ex ante equity capital, as classical capital ratios can be bypassed.

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Bibliographic Reference

Gersbach, H and Rochet, J. 2012. 'Capital Regulation and Credit Fluctuations'. London, Centre for Economic Policy Research.