DP10387 | Optimal capital requirements over the business and financial cycles

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I propose a simple theory of intertwined business and financial cycles, where financial regulation both optimally responds to and influences the cycles. In this model, banks do not internalize the effect of their credit expansion on other banks? expected bankruptcy costs, which leads to excessive aggregate lending. In response, the regulator sets a capital requirement to trade off expected output against financial stability. The capital requirement that ensures investment efficiency depends on the state of the economy and, because of a general equilibrium effect, its stringency increases with aggregate banking capital. A regulation that fails to take this effect into account would exacerbate economic fluctuations and result in excessive aggregate lending during a boom. It would also allow for an excessive build-up of risk in the financial sector, which implies that, at the peak of a boom, even a small adverse shock could trigger a banking sector collapse, followed by an excessively severe credit crunch.