Bank Leverage Regulation and Macroeconomic Dynamics

Regulatory constraints on bank leverage have been at the center of many policy discussions recently. One important question to emerge from these discussions has been whether these regulations should be time-dependent and how they would interact with the business cycle. We analyze this question using a dynamic stochastic general equilibrium model with banks and bank capital. In the model, bank capital emerges endogenously to solve an asymmetric information problem between banks and their creditors. The capital position of a bank thus affects its ability to attract loanable funds and, as a result, bank capital influences the business cycle through a bank capital channel of transmission. Government regulations on bank leverage interact with this channel. We use the model to conduct experiments on the strength of this interaction and find that regulations on bank leverage can have important effects on the dynamic responses of the economy to technology, financial and regulatory shocks.