Regulation and Rational Banking Bubbles in Infinite Horizon

Claire Chevallier and Sarah El Joueidi

DEM Discussion Paper Series from Department of Economics at the University of Luxembourg

Abstract: This paper develops a dynamic stochastic general equilibrium model in infinite horizon with a regulated banking sector where stochastic banking bubbles may arise endogenously. We analyze the conditions under which stochastic bubbles exist and their impact on macroeconomic key variables. We show that when banks face capital requirements based on Value-at- Risk, two different equilibria emerge and can coexist: the bubbleless and the bubbly equilibria. Alternatively, under a regulatory framework where capital requirements are based on credit risk only, as in Basel I, bubbles are explosive and, as a consequence, cannot exist. The stochastic bubbly equilibrium is characterized by positive or negative bubbles depending on the tightness of capital requirements based on Value-at-Risk. We find a maximum value of capital requirements under which bubbles are positive. Below this threshold, the stochastic bubbly equilibrium provides larger wel- fare than the bubbleless equilibrium. In particular, our results suggest that a change in banking policies might lead to a crisis without external shocks.

Keywords: Banking bubbles; banking regulation; DSGE; infinitely lived agents; multiple equilibria; Value-at-Risk (search for similar items in EconPapers)
JEL-codes: E2 E44 G01 G20 (search for similar items in EconPapers)
Date: 2016
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mac, nep-ore and nep-rmg
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