Capital Requirements, Risk-Taking and Welfare in a Growing Economy

Abstract

work is licensed under a Creative Commons IGO 3.0 AttributionNonCommercial-NoDerivatives (CC-IGO BY-NC-ND 3.0 IGO) license (http://creativecommons.org/licenses/by-nc-nd/3.0/igo/ legalcode) and may be reproduced with attribution to the IDB and for any non-commercial purpose, as provided below. No derivative work is allowed.Any dispute related to the use of the works of the IDB that cannot be settled amicably shall be submitted to arbitration pursuant to the UNCITRAL rules. The use of the IDB's name for any purpose other than for attribution, and the use of IDB's logo shall be subject to a separate written license agreement between the IDB and the user and is not authorized as part of this CC-IGO license.Following a peer review process, and with previous written consent by the Inter-American Development Bank (IDB), a revised version of this work may also be reproduced in any academic journal, including those indexed by the American Economic Association's EconLit, provided that the IDB is credited and that the author(s) receive no income from the publication. Therefore, the restriction to receive income from such publication shall only extend to the publication's author(s). With regard to such restriction, in case of any inconsistency between the Creative Commons IGO 3.0 Attribution-NonCommercial-NoDerivatives license and these statements, the latter shall prevail.Note that link provided above includes additional terms and conditions of the license. The effects of capital requirements on risk-taking and welfare are studied in a stochastic overlapping generations model of endogenous growth with banking, limited liability, and government guarantees. Capital producers face a choice between a safe technology and a risky (but socially inefficient) technology, and bank risk-taking is endogenous. Setting the capital adequacy ratio above a structural threshold can eliminate the equilibrium with risky loans (and thus inefficient risk-taking), but numerical simulations show that this may entail a welfare loss. In addition, the optimal ratio may be too high in practice and may concomitantly require a broadening of the perimeter of regulation and a strengthening of financial supervision to prevent disintermediation and distortions in financial markets. JEL classifications: E44, G28, O41

Risk Sharing, Macro-Prudential Policy and Welfare in an Overlapping Generations Model (OLG) Economy

“…Our paper shares the goal of finding rational macroprudential policies and their impact on the welfare with papers that have recently developed related to the topic, including Van den Heuvel (2019;2008), Agénor and da Silva (2017), Collard et al (2017), Boissay andCollard (2016), andClerc et al (2015).…”

“…Our model builds on a large literature which includes capital requirement and risk sharing and welfare. The most recent work related to this is the study by Agénor and da Silva (2017), where the authors studied the effects of capital requirements on risk taking and welfare in a stochastic overlapping model of endogenous growth with banking, limited liability, and government guarantees.…”

“…We model the relationship that affecting the economic growth between macroprudential regulation and risk sharing based on overlapping generation endogenous growth model based on the framework of Agénor and da Silva (2017). We model the risk sharing in financial institution in particular and the economy in general using the framework of Bohn (2009) and Gale (2010) because it provides a rational for the use of the modeling to introduce the behavior of risk sharing.…”

“…Also, our model suppose that the investment is financed by borrowing from banks and issuing equity to households. Finally, our paper shares the goal of finding a rationale for macroprudential policies with papers that have recently put the emphasis on risk sharing and endogenous economic growth, including Agénor and da Silva, (2017), Van den Heuvel (2019;2008), and Collard, et al (2017).…”

“…We need information friction to rule out a trivial and unrealistic solution in which the regulators directly forbid risk taking. As in (Van den Heuvel, 2019; 2008), (Collard et al, 2017) and (Agénor and da Silva, 2017), we assume that banks can hide some risky loans in their portfolio from regulators. More specifically we suppose that regulators observe the total amount of loans made by each bank but cannot detect its risky loans up to a given fraction 𝛾 of its safe loans.…”