Business Cycle and Bank Capital Regulation: Basel II Procyclicality

This paper studies the impacts of bank capital regulation on business cycle fluctuations. To do so, we adopt the Bernanke et al. (1999) "financial accelerator" model (BGG), to which we augment a banking sector to study the procyclical nature of Basel II claimed in the literature. We first study the impacts of a negative shock to entrepreneur's net worth and a positive monetary policy shock on business cycle fluctuations. We then look at the impacts of a negative shock to the entrepreneurs' net worth when the minimum capital requirement increases from 8 percent to 12 percent. Our comparison studies between the augmented BGG model with Basel I bank regulation and the one with Basel II bank regulation suggest that, in the presence of credit market frictions and bank capital regulation, the liquidity premium effect further ampliflies the financial accelerator effect through the external finance premium channel, which in turn, contributes to the amplification of Basel II procyclicality. Moreover, under Basel II bank regulation, in response to a negative net worth shock, the liquidity premium and the external finance premium rise much more if the minimum bank capital requirement increases, which in turn, amplify the response of real variables. Finally, small adjustments in monetary policy can result in stronger response in the real economy, in the presence of Basel II bank regulation in particular, which is undesirable.