Cyclical Capital Regulation and Dynamic Bank Behaviour

Abstract

In this paper we develop a dynamic model of bank behaviour to study cyclical capital regulation. We study the decision problem of a single bank that chooses its dividend policy and holds a portfolio of long-term loans (retail and corporate market), financed by internal (equity) and external (debt) funds. The demand for and return on bank lending is uncertain, determined by the state of the business cycle, which follows an exogenous Markov process. The model is calibrated using balance sheet and income statement data from seven of the largest Norwegian banking groups. To determine the probability and severity of a crisis we rely on cross-country data that covers several financial crises. In our main policy experiment we show that a time-varying capital requirement, which is decreased when loan losses are high, reduces the volatility of lending considerably compared with a fixed capital requirement. The reason for this is that lowering capital requirements when loan losses are high reduces the bank’s need to cut lending, relative to a fixed requirement.