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Capital Requirement and Financial Frictions in Banking: Macroeconomic Implications

Ali Dib

Staff Working Papers from Bank of Canada

Abstract: The author develops a dynamic stochastic general-equilibrium model with an active banking sector, a financial accelerator, and financial frictions in the interbank and bank capital markets. He investigates the importance of banking sector frictions on business cycle fluctuations and assesses the role of a regulatory capital requirement in propagating the effects of shocks in the real economy. Bank capital is introduced to satisfy the regulatory capital requirement, and serves as collateral for borrowing in the interbank market. Financial frictions are introduced by assuming asymmetric information between lenders and borrowers that creates moral hazard and adverse selection problems in the interbank and bank capital markets, respectively. Highly leveraged banks are vulnerable and therefore pay higher costs when raising funds. The author finds that financial frictions in the interbank and bank capital markets amplify and propagate the effects of shocks; however, the capital requirement attenuates the real impacts of aggregate shocks (including financial shocks), reduces macroeconomic volatilities, and stabilizes the economy.

Keywords: Economic models; Business fluctuations and cycles; Financial markets; Financial stability (search for similar items in EconPapers)
JEL-codes: E32 E44 G1 (search for similar items in EconPapers)
Pages: 51 pages
Date: 2010
New Economics Papers: this item is included in nep-ban, nep-bec, nep-cba, nep-cta, nep-dge, nep-mac and nep-reg
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:10-26

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