## Risky Bank Lending and Optimal Capital Adequacy Regulation

_IMF Working Papers, June 1, 2011_

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## Bibliographic details
- Authors: Jaromir Benes, Michael Kumhof
- Published: June 1, 2011
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781455259359.001

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### 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.
- Banks' main response to loan losses 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.
- The gains from eliminating limited liability and moral hazard would be an order of magnitude larger.

### Key findings and mechanisms
- Financial accelerator sector: Banks channel household deposits to a sector exhibiting financial accelerator effects; loan performance in this sector drives bank net worth dynamics.
- Unconditional lending rate: Loan contracts specify an unconditional lending rate, creating exposure to loan losses for banks when realized returns are adverse.
- Bank response to losses: Principal bank response is to increase lending rates, which affects credit supply and welfare.
- Prudential rule effects:
  - Adjusting minimum capital adequacy requirements in response to loan losses significantly increases welfare.
  - Eliminating limited liability and moral hazard produces welfare gains an order of magnitude larger than those from the prudential rules studied.

### Policy implications and recommendations
- Implement prudential rules that adapt minimum capital adequacy requirements to loan loss realizations to materially improve welfare.
- Consider deeper reforms addressing limited liability and moral hazard, as these yield substantially larger potential welfare improvements than adaptive capital adequacy rules alone.

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/risky-bank-lending-and-optimal-capital-adequacy-regulation-24900_