The effect of bank capital requirements on the real economy and their interaction with monetary policy
Gabriele Cozzi, Matthieu Darracq Pariès, Peter Karadi, Jenny Körner, Christoffer Kok, Falk Mazelis, Kalin Nikolov, Elena Rancoita, Alejandro Van der Ghote, Julien Weber 03 March 2020
Since the financial crisis, central banks and regulatory authorities have been given new powers to set macroprudential bank capital requirements (BIS 2018: Chapter IV, Cerruti et al. 2019). It is therefore important to understand how these instruments affect the economy at large. In a new paper (Cozzi et al. 2020), we lay out the implications of a number of important macro models at the ECB for the real impact of capital requirements as well as their interactions with monetary policy. This work is part of a broader research effort by the ECB to analyse the interactions between monetary policy and macroprudential policy. A companion paper (Albertazzi et al. 2020) takes an empirical perspective and reviews the evidence linking monetary policy and bank stability.
The real impact of capital requirements: A model comparison exercise
We start by comparing how a 1% increase in the minimum bank capital requirement affects real activity in four models frequently used for policy analysis at the ECB (Figure 1). The models are referred to with the acronyms DJP, DKR, NAWM II, and 3D.1
Figure 1 GDP and inflation evolution in response to a 1% increase in the minimum bank capital requirement in the 3D, DJP, DKR, and NAWM II models
The conduct of monetary policy also matters. The stronger that monetary policy leans against the negative effects of a capital-requirements increase on aggregate demand, the smaller the impact on output and inflation over the transition. Yet again, this suggests that the costs of imposing higher capital requirements may be elevated more when monetary policy is constrained by a binding effective lower bound on nominal interest rates.
The comparative model exercise reveals considerable similarities across the different analytical frameworks in the way the economy responds to an increase in bank capital requirements. All models incorporate a strong link between bank capital and credit supply, and all generate some decline in lending on impact as banks restrict credit supply. This reduces aggregate demand and leads to a modest but significant fall in GDP (peak decline of 0.15-0.35%) despite the reaction of the monetary authority, which lowers nominal interest rates.
Several interesting differences in both the short- and long-run behaviour of the different models can be seen in Figure 1. In the long run, the probability of bank default plays an important role; this explains why output fully recovers in the 3D model, in which bank default plays an important role. Making banks safer using higher…