Business Cycle and Bank Capital Regulation: Basel II Procyclicality

Guangling Liu () and Nkhahle Seeiso ()
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Nkhahle Seeiso: Department of Economics, University of Stellenbosch

No 18/2011, Working Papers from Stellenbosch University, Department of Economics

Abstract: This paper studies the impact of bank capital regulation on business cycle fluctuations. In particular, we study the procyclical nature of Basel II claimed in the literature. To do so, we adopt the Bernanke et al. (1999) ``financial accelerator" model (BGG), to which we augment a banking sector. We first study the impact of a negative shock to entrepreneurs' net worth and a positive monetary policy shock on business cycle fluctuations. We then look at the impact of a negative net worth shock on business cycle fluctuations when the minimum capital requirement increases from 8 percent to 12 percent. Our comparison studies between the augmented BGG model with Basel I bank regulation and the one with Basel II bank regulation suggest that, in the presence of credit market frictions and bank capital regulation, the liquidity premium effect further amplifies the financial accelerator effect through the external finance premium channel, which, in turn, contributes to the amplification of Basel II procyclicality. Moreover, under Basel II bank regulation, in response to a negative net worth shock, the liquidity premium and the external finance premium rise much more if the minimum bank capital requirement increases, which, in turn, amplify the response of real variables. Finally, small adjustments in monetary policy can result in stronger response in the real economy, in the presence of Basel II bank regulation in particular, which is undesirable.

Keywords: Business cycle fluctuations; financial accelerator; bank capital requirement; monetary policy (search for similar items in EconPapers)
JEL-codes: E32 E44 E50 G28 (search for similar items in EconPapers)
Date: 2011
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mac and nep-reg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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