The effectiveness of countercyclical capital requirements and contingent convertible capital: a dual approach to macroeconomic stability

This paper studies the effectiveness of countercyclical capital requirements and contingent convertible capital (CoCos) in limiting financial instability, and its associated influence on the real economy. To do this, I augment both features into a standard real business cycle framework with an equity market and a banking sector. The model is calibrated to real U.S. data and used for simulations. The findings suggest that CoCos effectively re-capitalize the banking sector and foster the objectives of countercyclical capital requirements (i.e., Basel III). Under financial shocks, CoCos provide an effective automatic stabilization effect on the financial cycle and the real economy. Conversely, a countercyclical capital adequacy rule dominates CoCos in the stabilization of real shocks.