Cyclical Implications of Changing Bank Capital Requirements in a Macroeconomic Framework

IMF Working Papers, August 1, 2005

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Presents an intertemporal general equilibrium framework that accounts for the effects of capital requirement policies on households' saving decisions and, through this channel, on bank loans and output.
Evaluates optimal responses to two shock types:
- Loan supply shocks (reduced loan supply).
- Productivity (loan demand) shocks (reduced productivity / loan demand).

Common view summarized: "Bank capital requirements should be loosened during recessions and tightened during expansions to avoid excessive credit and output swings."
Critique of common view: That view is based on a partial analysis that ignores effects on household saving decisions and subsequent impacts on loans and output.
When loan supply is reduced:
- Increasing the capital requirement allows a faster recovery of households' savings, loans, and output than a flat capital requirement policy.
When productivity (loan demand) is reduced:
- Lowering the capital requirement facilitates households' dissaving and amplifies the output decline, but enhances welfare.
If productivity reductions are anticipated (rather than unanticipated) by regulators:
- Lowering the capital requirement preemptively enhances welfare through greater intertemporal smoothing of households' consumption and deposit holdings.

Policy prescriptions that ignore household saving responses may be misleading.
Optimal capital requirement responses depend on the shock type:
- For loan supply reductions, consider increasing capital requirements to speed recovery of savings, loans, and output.
- For productivity/loan demand reductions, lowering capital requirements can improve welfare despite amplifying output declines by facilitating household dissaving.
- If productivity reductions are anticipated, preemptive lowering of capital requirements can enhance welfare via better intertemporal smoothing of consumption and deposits.
Regulatory timing and information (anticipated vs. unanticipated shocks) materially affect welfare outcomes and should inform capital requirement policy design.