Optimal capital requirements over the business and financial cycles
|Speaker:||Frederic Malherbe, London Business School|
|Date: ||Friday 2 October 2015|
|Location: ||Matrix Lecture Theatre, Building One|
I study economies where banks do not fully internalize the social costs of default. In these economies, a common general equilibrium effect leads to aggregate over-investment. Under laissez-faire, crises are too frequent and too costly. The bank capital requirement that ensures investment efficiency (trading off expected output against financial stability) depends on the state of the economy. Due to the general equilibrium effect, the more aggregate bank capital the tighter the optimal requirement. If regulation overlooks this effect, this exacerbates economic fluctuations and allows for excessive build-up of risk in the financial sector during booms. Government guarantees amplify this mechanism.