How does macroprudential regulation change bank credit supply?

Abstract

We analyze a variant of the Diamond-Dybvig (1983) model of banking in which savers can use a bank to invest in a risky project operated by an entrepreneur. The savers can buy equity in the bank and save via deposits. The bank chooses to invest in a safe asset or to fund the entrepreneur. The bank and the entrepreneur face limited liability and there is a probability of a run which is governed by the bank's leverage and its mix of safe and risky assets. The possibility of the run reduces the incentive to lend and take risk, while limited liability pushes for excessive lending and risk-taking. We explore how capital regulation, liquidity regulation, deposit insurance, loan to value limits, and dividend taxes interact to offset these frictions. We compare agents welfare in the decentralized equilibrium absent regulation with welfare in equilibria that prevail with various regulations that are optimally chosen. In general, regulation can lead to Pareto improvements but fully correcting both distortions requires more than one regulation.

What Do We Know About the Effects of Macroprudential Policy?

“…Second, they are mostly partial equilibrium models, and the existence of many feedback mechanisms between the behaviour of different types of agents and regulatory instruments calls for a general equilibrium framework (Kashyap et al . ).…”

“…First, to be tractable, these models typically neglect the role of time and the business cycle, which makes it more difficult to study macroprudential tools that address externalities related to the procyclicality of the financial system. Second, they are mostly partial equilibrium models, and the existence of many feedback mechanisms between the behaviour of different types of agents and regulatory instruments calls for a general equilibrium framework (Kashyap et al 2014).…”

“…Another type of three-period general equilibrium model captures the different roles that banks play in the economy-providing liquidity insurance for savers, improving the risk-sharing opportunities for savers, increasing the amount of funding available to borrowers (Kashyap et al 2014). These models can be used to analyse alternative causes of the global financial crisis-excessive risk-taking by under-capitalized banks that were exploiting taxpayer support, funding vulnerabilities in the financial system and bank runs -and regulatory tools that can help to prevent future crises.…”

Optimal Dynamic Capital Requirements

“…The focus on bank fragility is shared with Markovic (), Zhang (), and Hirakata, Sudo, and Ueda (), which model bank default in a way similar to ours but do not provide a normative analysis of capital requirements. Angeloni and Faia () and Kashyap, Tsomocos, and Vardoulakis () look at the fragility induced by bank runs. Aoki and Nikolov () focus on safety net distortions, Boissay, Collard, and Smets () on interbank market frictions, and Martinez‐Miera and Suarez (), and Collard et al.…”

The Conceptual Foundations of Macroprudential Policy: A Roadmap

“…Optimal Pigouvian taxation should reflect the fact that agents’ welfare will generally be affected differently (Biljanovksa ); hence different tools may be required depending on the Pareto weights assigned to different agents (Kashyap et al ).…”