By Gianni De Nicolo, Nataliya Klimenko, Sebastian Pfeil and Jean-Charles Rochet
We build a stylized dynamic general equilibrium model with financial frictions to analyze costs and benefits of capital requirements in the short-term and long-term. We show that since increasing capital requirements limits the aggregate loan supply, the equilibrium loan rate spread increases, which raises bank profitability and the market-to-book value of bank capital. Hence, banks build up larger capital buffers which (i) lowers the public losses in case of a systemic crisis and (ii) restores the banking sector’s lending capacity after the short-term credit crunch induced by tighter regulation. We confirm our model’s dynamic implications in a panel VAR estimation, which suggests that bank lending has even increased in the long-run after the implementation of Basel III capital regulation.
People have been afraid that implicit or explicit tightening of capital requirements would hinder lending in Basel III. But with less risk in banks, their ability to raise funds and lend improves. It is cool such model predictions from before Basel III can be seen in real live, this was true out-of-sample forecasting.