Banking Dynamics and Capital Regulation: José Víctor Ríos Rull at CERGE-EI

On 7 March, José Víctor Ríos Rull, Lawrence R. Klein Professor of Economics at the University of Pennsylvania, gave an ADEMU public lecture at CERGE-EI. Here, ADEMU postgraduate researchers Ivo Bakota and Vladimír Novák provide proceedings from the lecture.

José Víctor Ríos Rull  presented the joint work in progress with Tamon Takamura and Yaz Terajima (both Bank of Canada).

Recent regulatory approaches such as Basel III have introduced the counter cyclical capital buffers, for example to ease regulation during recessions, because the recession automatically makes the capital requirement tighter by reducing the value of assets and because banking activity is more socially valuable.

Also, a tight requirement would induce some banks to reduce drastically their lending to comply if adversely affected. The authors want to investigate a change in capital requirements on the onset of a recession and to measure the trade-offs involved when taking into account many (quantitatively) relevant features.

They start by modelling the bank in a way that includes two important features. First, that banks may be worth saving even if bankrupt and that developing of the bank takes time, because they grow slowly in size due to exogenous loan productivity process and need for internal accumulation of funds.

Consequently they study the model in an economy that resembles a current distribution of banks using data from Canada. They then explore what happens upon the economy entering a recession under various scenarios.

The temporary results show that lowering capital requirements has little effect because banks are already concerned. Changing the capital requirements has very small effects on dividends, bank default probability and average capital ratio. In the future work they want to replicate the industry structure more properly and to address several other shortcomings in a greater detail.