Twin defaults and bank capital requirements
Caterina Mendicino (),
Kalin Nikolov (),
Javier Suarez () and
No 2414, Working Paper Series from European Central Bank
We examine optimal capital requirements in a quantitative general equilibrium model with banks exposed to non-diversifiable borrower default risk. Contrary to standard models of bank default risk, our framework captures the limited upside but significant downside risk of loan portfolio returns (Nagel and Purnanandam, 2020). This helps to reproduce the frequency and severity of twin defaults: simultaneously high firm and bank failures. Hence, the optimal bank capital requirement, which trades off a lower frequency of twin defaults against restricting credit provision, is 5pp higher than under standard default risk models which underestimate the impact of borrower default on bank solvency. JEL Classification: G01, G28, E44
Keywords: bank assets returns; default risk; financial intermediation; macroprudential policy (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20202414
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