Financial System Procyclicality and Optimal Capital Requirement Policy: Revisiting Countercyclical Responses

Solikin Juhro and Denny Lie

No 2024-22, Working Papers from University of Sydney, School of Economics

Abstract: This paper analyzes the optimal interaction between monetary and capital requirement policies in an estimated medium-scale DSGE model featuring a wide array of shocks, where a trade-off exists between macroeconomic and financial stability. We show that the optimal capital requirement policy is not necessarily countercyclical, as commonly recommended in the literature, but can instead be procyclical. Indeed, for most shocks in our model, as well as when considering all shocks collectively, the optimal response is procyclical. While multiple factors shape this result, financial frictions play a key role: a higher degree of financial friction increases the likelihood that countercyclical capital requirements become optimal. The associated welfare gains from adopting the optimal policy are non-trivial, particularly under financial and cost-push shocks, even when monetary policy is already optimized. Our central, general finding---the potential desirability of procyclical capital requirement policy---extends beyond our model and applies to other economies. The key conditions for this result are the presence of shocks that create a trade-off between macroeconomic and financial stability and a policymaker objective of maximizing the welfare of economic agents. Under these conditions, countercyclical capital requirements could lead to significant welfare losses.

Keywords: monetary policy; macroprudential policy; policy mix; financial system procyclicality; capital requirement; countercyclical or procyclical policy; welfare analysis (search for similar items in EconPapers)
Date: 2024-10, Revised 2025-01
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-fdg, nep-mon and nep-sea
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