Optimal Capital Regulation with Two Banking Sectors
Abstract:
We present the case for procyclical capital requirement policy { lower requirement during booms and higher requirement during recessions { as opposed to the generally accepted countercyclical requirement in the current literature. Our argument is based on the fact that banks shift their capital into and out of the ambit of regulation depending on the severity of the regulation. The banks trade off the benefit of being regulated { cheaper funding/insurance { with the cost { restriction on the portfolio risk. Tightening the capital requirement during a boom (as in a countercyclical policy) forces the banks to move to the shadow banking sector where they take too much risk. Therefore, the policy aimed at controlling the risk banks take during booms should incentivize the banks to be regulated by relaxing the capital requirement. These forces are reversed during recessions. The policy specifies the level of capital requirement as a function of the relative size of the two banking sectors. Under this specification, the right mix of the two sectors is achieved even when, in equilibrium, the banks are indifferent between being regulated and unregulated. We show that the regulation policy is robust to estimation errors in the model parameters in that small errors lead to welfare loss that is an order smaller
