Time-Varying Capital Requirements In A General Equilibrium Model Of Liquidity Dependence

This paper attempts to quantify business cycle effects of bank capital requirements. The authors use a general equilibrium model in which financing of capital goods production is subject to an agency problem. At the center of this problem is the interaction between entrepreneurs' moral hazard and liquidity provision by banks as analyzed by Holmstrom and Tirole (1998) They impose capital requirements on banks and calibrate the regulation using the Basel II risk-weight formula. Comparing business cycle properties of the model under this procyclical regulation with those under hypothetical countercyclical regulation, they find that output volatility is about 25% larger under procyclical regulation and that this volatility difference implies a 1.7% reduction of the household's welfare.