Risky Bank Lending and Optimal Capital Adequacy Regulation

Author/Editor:

Jaromir Benes ; Michael Kumhof

Publication Date:

June 1, 2011

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

We study the welfare properties of a New Keynesian monetary economy with an essential role for risky bank lending. Banks lend funds deposited by households to a financial accelerator sector, and face penalties for maintaining insufficient net worth. The loan contract specifies an unconditional lending rate, which implies that banks can make loan losses. Their main response is to raise lending rates to rebuild net worth. Prudential rules that adjust minimum capital adequacy requirements in response to loan losses significantly increase welfare. But the gains from eliminating limited liability and moral hazard would be an order of magnitude larger.

Series:

Working Paper No. 2011/130

Subject:

English

Publication Date:

June 1, 2011

ISBN/ISSN:

9781455259359/1018-5941

Stock No:

WPIEA2011130

Pages:

27

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