Essays on Banking Regulation, Macroeconomic Dynamics and Financial Volatility

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Abstract

The recent global financial crisis of 2007-2009 and the subsequent recession have prompted renewed interest into how banking regulation and fluctuations in the financial sector impact the business cycle. Using three different model setups, this thesis promotes a further understanding and identification of the various transmission channels through which regulatory changes and volatility in the financial system link to the real economy.Chapter 1 examines the effects of bank capital requirements in a simple macroeconomic model with credit market frictions. A bank capital channel is introduced through a monitoring incentive effect of bank capital buffers on the repayment probability, which affects the loan rate behaviour via the risk premium. We also identify a collateral channel, which mitigates moral hazard behaviour by firms, and therefore raises their repayment probability. Basel I and Basel II regulatory regimes are then defined, with a distinction made between the Standardized and Foundation Internal Ratings Based (IRB) approaches of Basel II. We analyse the role of the bank capital and collateral channels in the transmission of supply shocks, and show that depending on the strength of these channels, the loan rate can either amplify or mitigate the effects of productivity shocks. Finally, the impact of the two channels also determines which of the regulatory regimes is most procyclical.Chapter 2 studies the interactions between bank capital regulation and the real business cycle in a Dynamic Stochastic General Equilibrium (DSGE) framework with financial frictions, along with endogenous risk of default at the firm and bank capital levels. We show that in a model which accounts for bank capital risk and regulatory requirements, the endogenous risk of default produces an accelerator effect and impacts the loan rate and the real economy through multiple channels. Furthermore, the simulations illustrate that a risk sensitive regulatory regime (Basel II) amplifies the response of macroeconomic and financial variables following supply, monetary and financial shocks, with the strength of the key transmission channels depending on the nature of the shock. The impact of higher regulatory requirements (as proposed under Basel III) is also examined and is shown to increase procyclicality in the financial system and real economy.Chapter 3 studies the interactions between loan loss provisions and business cycle fluctuations in a Dynamic Stochastic General Equilibrium (DSGE) model with credit market imperfections. With a backward-looking provisioning system, provisions are triggered by past due payments (or nonperforming loans), which, in turn, depend on current economic conditions and the loan loss reserves-loan ratio. With a forward-looking system, both past due payments and expected losses over the whole business cycle are accounted for, and provisions are smoothed over the cycle. Numerical experiments based on a parameterized version of the model show that holding more provisions can reduce the procyclicality of the financial system. However, a forward-looking provisioning regime can increase or lower procyclicality, depending on whether holding more loan loss reserves translates into a higher or lower fraction of nonperforming loans.

Keyword(s)

Banking Regulation; Basel Accords; Financial - Real Business Cycle Linkages; Procyclicality

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