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Do Capital Adequacy Requirements Really Matter?

Economic Research Institute(+82-2-759-5477) 2008.05.28 5741
 This paper investigates how the bank capital adequacy requirements affect economic fluctuations. It is widely claimed that when bank loans are bounded by bank capital, as the Basel Accord stipulates, economic fluctuations are amplified. However, since banks would hold capital even without the regulation and thereby the amplifying effect must already exist, it is unclear how much additional amplification effect the regulation itself creates. This paper answers this question. Following the literature the bank loan and the bank capital are modeled from dual layers of information asymmetry and incorporated into an otherwise standard New Keynesian model. With reasonable parameter values for Korean economy, I find that the capital adequacy requirements add little to the economic fluctuations beyond what already caused by the information asymmetry. It is true even when the regulation is sensitive to the business cycle. If the bank re-capitalization by outside funds is allowed, the amplifying effect may even become smaller. This implies that the monetary policy framework does not need to be altered in response to the adoption of the Basel II capital regulation.

Keywords: Capital adequacy requirement, Procyclicality, Information asymmetry, Basel accord
JEL Classification: E44; E52; G20