Macroeconomic Modeling of Financial Frictions for Macroprudential Policymaking: A Review of Pressing Challenges

Abstract

This paper examines the optimal design of and interaction between capital and liquidity regulations in a model characterized by fire sale externalities. In the model, banks can insure against potential liquidity shocks by hoarding sufficient precautionary liquid assets. However, it is never optimal to fully insure, so realized liquidity shocks trigger an asset fire sale. Banks, not internalizing the fire sale externality, overinvest in the risky asset and underinvest in the liquid asset in the unregulated competitive equilibrium. Capital requirements can lead to less severe fire sales by addressing the inefficiency and reducing risky assets-however, we show that banks respond to stricter capital requirements by decreasing their liquidity ratios. Anticipating this response, the regulator preemptively sets capital ratios at high levels. Ultimately, this interplay between banks and the regulator leads to inefficiently low levels of risky assets and liquidity. Macroprudential liquidity requirements that complement capital regulations, as in Basel III, restore constrained efficiency, improve financial stability and allow for a higher level of investment in risky assets.

Macroprudential Policy and Labor Market Dynamics in Latin America

“…8 See Kiley and Sim (2012) for the United States, Benigno et al (2013) and Filiz Unsal ( 2013) for two open-economy applications, and González, Hamann, and Rodríguez (2013) for a commodity-exporting economy, among many others. Also, see Bianchi, Boz, and Mendoza (2012) and the references therein for a different set of models that abstract from nominal rigidities and monetary policy.…”