Capital Regulation, Monetary Policy, ∗ and Financial Stability Pierre-Richard Ag´enor,a Koray Alper,b and Luiz Pereira da Silvac aUniversity of Manchester and Centre for Growth and Business Cycle Research bCentral Bank of Turkey cCentral Bank of Brazil This paper examines the roles of bank capital regula- tion and monetary policy in mitigating procyclicality and promoting macroeconomic and financial stability. The analy- sis is based on a dynamic stochastic model with imperfect credit markets. Macroeconomic stability is defined in terms of a weighted average of inflation and output-gap volatil- ity, whereas financial stability is defined in terms of three alternative indicators (real house prices, the credit-to-GDP ratio, and the loan spread), both individually and in com- bination. Numerical experiments associated with a housing demand shock show that in a number of cases, even if mon- etary policy can react strongly to inflation deviations from target, combining a credit-augmented interest rate rule and a Basel III-type countercyclical capital regulatory rule may be optimal for promoting overall economic stability. The greater the degree of policy interest rate smoothing, and the stronger ∗Wewouldliketothanktheeditor,ananonymousreferee,participantsatthe ECB workshop on The Bank Lending Channel in the Euro Area: New Models andEmpiricalAnalysis(Frankfurt,June24–25),andparticularlyourdiscussant, Javier Suarez, as well as participants at seminars at the European University Institute and the University of Manchester, for helpful comments on a previ- ous draft. Financial support from the PREM Network of the World Bank is gratefully acknowledged. A more detailed version of this article, containing the appendices, is available upon request. We bear sole responsibility for the views expressed here. Agenor: Professor, School of Social Sciences, University of Man- chester,UnitedKingdom,andco-Director,CentreforGrowthandBusinessCycle Research; Alper: Director, Open Market Operations, Central Bank of Turkey; Pereira da Silva: Deputy Governor, Central Bank of Brazil. 193 194 International Journal of Central Banking September 2013 thepolicymaker’sconcernwithfinancialstability,thelargeris the sensitivity of the regulatory rule to credit growth gaps. JEL Codes: E44, E51, F41. “Preserving financial stability is so closely related to the stan- dard goals of monetary policy (stabilizing output and inflation) that it ... seems somewhere between foolish and impossible to separate the two functions.” Alan S. Blinder, “How Central Should the Central Bank Be?” (2010, p. 12) “Ensuring financial stability requires a redesign of macroeco- nomic as well as regulatory and supervisory policies with an eye to mitigating systemic risks. For macroeconomic policies, this means leaning against credit and asset price booms; for regulatoryandsupervisorypolicies,itmeansadoptingamacro- prudential perspective.” Bank for International Settlements, “79th Annual Report” (2009, p. 14) 1. Introduction The recent crisis in global financial markets has led to a substan- tialnumberofproposalsaimedatstrengtheningthefinancialsystem andatencouragingmoreprudentlendingbehaviorinupturns.Many of these proposals aim to mitigate the alleged procyclical effects of Basel II capital standards. Indeed, several observers have argued that by raising capital requirements in a contracyclical way, reg- ulators could help to slow credit growth and choke off asset-price pressures before a crisis occurs. A recent proposal along these lines, put forward by Goodhart and Persaud (2008), involves essentially adjusting the Basel II capital requirements to take into account and act at the relevant point in the economic cycle.1 In particular, in the 1Buiter (2008) extended the Goodhart-Persaud proposal by suggesting that capital and liquidity requirements be applied to all highly leveraged financial institutions, not only banks. Vol. 9 No. 3 Capital Regulation, Monetary Policy 195 Goodhart-Persaud proposal, the capital adequacy requirement on mortgage loans would be linked to the rise in both mortgage lend- ing and house prices.2 The Turner Review (See Financial Services Authority2009)alsofavorscountercyclicalcapitalrequirements,and so do Brunnermeier et al. (2009), who propose to adjust capital ade- quacyrequirementsoverthecyclebytwomultiples—thefirstrelated to above-average growth of credit expansion and leverage, the sec- ondrelatedtothemismatchinthematurityofassetsandliabilities.3 At the policy level, there has been concrete progress toward estab- lishing new standards in this area; the Basel Committee on Bank- ing Supervision (BCBS) has developed a countercyclical framework that involves adjusting bank capital in response to excess growth in credit to the private sector, which it views as a good indicator of systemic risk. On November 12, 2010, G20 leaders adopted BCBS’s proposal to implement a countercyclical capital buffer ranging from 0 to 2.5 percent of risk-weighted assets, as part of the new Basel III framework (see Basel Committee on Banking Supervision 2010). At the same time, the global financial crisis has led to renewed calls for central banks (and regulators) to consider more systemat- ically potential trade-offs between the objectives of macroeconomic stability and financial stability, or equivalently whether the central bank’s policy loss function (and therefore its interest rate response) should account explicitly for a financial stability goal. The issue is not new; it has long been recognized, for instance, that an increase in interest rates aimed at preventing the development of inflation- ary pressures may, at the same time, heighten uncertainty and fos- ter volatility in financial markets. The debate (which predates the recent crisis) has focused on the extent to which monetary policy should respond to perceived misalignments in asset prices, such as 2Goodhart and Persaud argue that their proposal could be introduced under the second pillar of Basel II. While Pillar 1 consists of rules for requiring mini- mumcapitalagainstcredit,operational,andmarketrisks,Pillar2issupposedto takeintoaccountalltheadditionalriskstowhichabankisexposed,inorderto arriveatitsactualcapitalneeds.However,byusingonlyPillar2atthediscretion of local regulators, it can allow banks to engage in regulatory arbitrage. 3Although not as explicit, Blinder (2010) has also endorsed the view that centralbanksshouldtrytolimitcredit-basedbubblesthroughregulatoryinstru- ments(ratherthaninterestrates)andreferstoitaspossiblybecomingthe“new consensus” on how to deal with asset-price bubbles. 196 International Journal of Central Banking September 2013 realestateandequityprices.4 Inthatcontext,severalobservershave argued that trying to stabilize asset prices per se is problematic for a number of reasons—one of which being that it is almost impossi- ble to know for sure whether a given change in asset values results from changes in underlying fundamentals, non-fundamental factors, or both. By focusing on the implications of asset-price movements for credit growth and aggregate demand, the central bank may be abletofocusontheadverseeffectsofthesemovements—withoutget- ting into the tricky issue of deciding to what extent they represent changes in fundamentals. This paper is an attempt to address both sets of issues in a uni- fied framework. We examine the role of both monetary policy and a capital regulation rule that bears close similarity to some recent proposalstomitigatetheprocyclicaltendenciesoffinancialsystems, and we evaluate their implications for macroeconomic stability and financial stability—defined in terms of the combined volatility of inflation and the output gap, on the one hand, and the volatility of a measure of potential financial stress, on the other. We do so under a Basel II-type regime, with endogenous risk weights on bank assets. Among the issues that we attempt to address are the fol- lowing: to promote financial stability, how should countercyclical bank capital requirement rules be designed? Instead of adding a cyclical component to prudential regulation, shouldn’t policymakers use monetary policy to constrain credit growth directly? To what extentshouldregulatorypolicyandmonetarypolicybecombinedto ensure both macroeconomic and financial stability? Put differently, are these policies complementary or substitutes? Quantitative studies of these issues are important for a num- ber of reasons. Regarding the design of countercyclical bank capital rules, several observers have noted that there are indeed significant potentialpracticalproblemsassociatedwiththeirimplementation— including the period over which relevant financial indicators (credit growth rates, for that matter) should be calculated. More impor- tant perhaps is the possibility that these rules may operate in counterintuitive ways, depending on the degree of financial-sector 4See,forinstance,Chadha,Sarno,andValente(2004),Filardo(2004),Akram, Bardsen, and Eitrheim (2006), Faia and Monacelli (2007), and Akram and Eitrheim (2008). Wadhwani (2008) provides a brief overview of the literature. Vol. 9 No. 3 Capital Regulation, Monetary Policy 197 imperfections. In particular, in countries where bank credit plays a critical role in financing short-term economic activity (as is often the case in developing economies), a rule that constrains the growth in overall credit could entail a welfare cost. At the same time, of course, to the extent that it succeeds in reducing financial volatility and the risk of a full-blown crisis, it may also enhance welfare. The net benefits of countercyclical bank capital rules may therefore be ambiguous in general and numerical evaluations become essential. Regarding the role of monetary policy, the key issue is whether a central bank with a preference for output and price stability can improve its performance with respect not only to these two objec- tives but also to financial stability, by responding to excessive move- ments in credit and/or asset prices in addition to fluctuations in prices and activity. In a relatively complex model, understanding the conditions that may lead to trade-offs among objectives often requires quantitative experiments. To conduct our analysis, we extend the New Keynesian model described in Ag´enor, Alper, and Pereira da Silva (2012). Important features of that model are that it accounts explicitly for a variety of creditmarketimperfectionsandbankcapitalregulation.5 Ahousing sector is introduced, and the role of real estate as collateral exam- ined.Specifically,weestablishadirectlinkbetweenhousepricesand credit growth via their impact on collateral values and interest rate spreads on loans: higher house prices enable producers to borrow and invest more, by raising the value of the collateral that they can pledge and improving the terms at which credit is extended. This mechanism is consistent with the evidence suggesting that a large value of bank loans to (small) firms, in both industrial and devel- oping countries, is often secured by real estate. To capture financial 5There is a small but growing literature on the introduction of capital reg- ulation in New Keynesian models with banking; recent papers include Aguiar andDrumond(2007),Dib(2009,2010),Hirakata,Sudo,andUeda(2009),Gerali etal.(2010),andMehandMoran(2010).Somecontributionshavealsoattempted to integrate countercyclical regulatory rules in this type of model; they include Kannan,Scott,andRabanal(2009),Levieuge(2009),AngeloniandFaia(2010), Covas and Fujita (2010), Darracq Pari`es, Kok Sorensen, and Rodriguez Palen- zuela (2010), and Angelini, Neri, and Panetta (2011). However, as is made clear later, our approach differs significantly from all of these contributions, making comparisons difficult. 198 International Journal of Central Banking September 2013 instability, we consider three alternative indicators, both individu- ally and in combination: real house prices, the credit-to-GDP ratio, and the loan spread.6 This is also in line with the literature suggest- ingthatfinancialcrisesareoftenprecededbyunsustainabledevelop- ments in the real-estate sector and private-sector credit, and a large increase in bank interest rate spreads.7 In this context we examine the implications of two alternative policy rules for economic stability: a standard Taylor-type interest rate rule augmented to account for credit growth and (in line with the Basel III regime) a countercyclical regulatory rule that relates capital requirements also to credit growth. Our numerical experi- ments show that even if monetary policy can react strongly to infla- tion deviations from target, combining a credit-augmented interest rate rule and a Basel III-type countercyclical capital regulatory rule maybeoptimalforpromotingoveralleconomicstability.Thegreater the degree of interest rate smoothing, and the stronger the policy- maker’s concern with financial stability (when measured in terms of either the credit-to-GDP ratio and/or loan spread volatility), the larger is the sensitivity of the regulatory rule to credit growth gaps. Thepapercontinuesasfollows.Section2presentsthemodel.We keep the presentation very brief, given that many of its ingredients aredescribedatlengthinAg´enor,Alper,andPereiradaSilva(2012); instead, we focus on how the model presented here departs from that paper, especially with respect to the financial sector and coun- tercyclical policy rules. The equilibrium is characterized in section 3. Key features of the steady state and the log-linearized version, as well as a brief discussion of an illustrative calibration, are discussed in section 4. We present in section 5 the impulse response functions associated with our base experiment: a temporary, positive housing demand shock. Section 6 discusses the two alternative countercycli- cal rules alluded to earlier, involving an augmented monetary policy ruleandacapitalregulatoryrule,bothdefinedintermsofdeviations 6The concept of financial stability has remained surprisingly elusive in the existingliterature;seeGoodhart(2006).Ourfocusinthispaperisonalternative, operational, quantitative measures of financial instability. 7See Calder´on and Fuentes (2011) and International Monetary Fund (2011). Gerdesmeier, Reimers, and Roffia (2010) found that credit aggregates also play a significant role in predicting asset-price busts in industrial countries. Vol. 9 No. 3 Capital Regulation, Monetary Policy 199 in credit growth and aimed at promoting stability. Section 7 inves- tigates whether the use of these rules (taken in isolation) generates gains in terms of both financial and macroeconomic stability, that is, whether they entail a trade-off among objectives; to do so we present simulation results of the same housing demand shock under bothtypesofrules,forsomespecificparametervalues.Section8dis- cussesoptimalpolicyrules,whentheobjectiveofthecentralbankis tominimizevolatilityinameasureof“economicstability,”definedas a weighted average of separate measures of macroeconomic stability and financial stability. Section 9 provides some sensitivity analysis. The last section provides a summary of the main results and dis- cusses the implications of our analysis for the ongoing debate on reforming bank capital standards. 2. Outline of the Model The core model presented in this paper departs from Ag´enor, Alper, andPereiradaSilva(2012)essentiallybyintroducingahousingmar- ket and linking it with collateral and loans for investment purposes. To save space, this section provides only a brief outline of the model in most respects—except for bank regulation and the optimization problem of the bank, for which a more formal analysis is presented.8 We consider a closed economy populated by six types of agents: infinitelylivedhouseholds,intermediategood(IG)producers,afinal good (FG) producer, a capital good (CG) producer, a monopoly commercialbank,thegovernment,andthecentralbank,whoseman- date also includes bank regulation. The final good is homogeneous and can be used either for consumption or investment, although in the latter case additional costs must be incurred. There are two types of households, constrained and uncon- strained.9 Constrained households do not participate in asset mar- kets and follow a rule of thumb which involves consuming all their 8Adetailed,formalpresentationofthemodelisavailableintheworkingpaper version of this article, which is available upon request. 9As discussed later, the distinction between these two types of households is useful to understand the dynamics of consumption following housing demand shocks. See Ag´enor and Montiel (2008) for a discussion of why consumption smoothing may be imperfect in the context of developing countries. 200 International Journal of Central Banking September 2013 after-tax disposable wage income in each period. They also sup- plylaborinelastically.Unconstrained households consume,cantrade in asset markets and hold financial assets (including nominal debt issued by the bank), and supply labor to IG producers. As in Iacoviello (2005), Silos (2007), and Iacoviello and Neri (2008), hous- ing services are assumed to be proportional to their stock, which enters directly in the utility function. These households also make theirhousingstockavailable,freeofcharge,totheCGproducer,who uses it as collateral against which it borrows from the bank to buy the final good and produce capital. At the beginning of the period, unconstrained households choose the real levels of cash, deposits, bank debt, government bonds, and labor supply to IG firms. They receive all the profits made by the IG producers, the CG producer, and the bank, and pay a lump-sum tax. Optimization yields a standard Euler equation and a standard labor supply function, which relates hours worked positively to the real wage and negatively to consumption. It also yields three asset demand equations: the first relates the real demand for cash pos- itively to consumption and negatively to the opportunity cost of holding money, measured by the interest rate on government bonds; the second relates the real demand for deposits positively to con- sumption and the deposit rate, and negatively to the bond rate; and the third is the demand for bank debt, Vd, which is given by t (cid:2) (cid:3) Vd iV −iB t = Θ−1 t t , (1) P V 1+iB t t where Θ ≥ 0 denotes an adjustment cost parameter that captures V transactions costs associated with changes in household holdings of bank capital, P the price of the final good, iB the bond rate, and t t iV the rate of return on bank debt. Thus, the demand for bank debt t depends positively on its rate of return and negatively on the bond rate. Similarly, there is a demand function for housing services, from which it can be established that a positive shock to preferences for housingleads(allelseequal)toariseintoday’sdemandforhousing. The FG producer’s optimization problem is specified in stan- dard fashion. The final good, which is allocated to private con- sumption, government consumption, and investment, is produced byassemblingacontinuumofimperfectlysubstitutableintermediate Vol. 9 No. 3 Capital Regulation, Monetary Policy 201 goods. The FG producer sells its output at a perfectly competitive price. Given the intermediate goods prices and the final good price, it chooses the quantities of intermediate goods that maximize its profits. IG producers produce, using capital and labor, a distinct per- ishable good that is sold on a monopolistically competitive market. At the beginning of the period, each IG producer rents capital from the CG producer and borrows to pay wages in advance. Loans con- tractedforthepurposeoffinancingworkingcapital(whichareshort term in nature) do not carry any risk, and are therefore made at a rate that reflects only the marginal cost of borrowing from the cen- tral bank, iR, which we refer to as the refinance rate. These loans t are repaid at the end of the period. IG producers solve a two-stage problem. In the first stage, taking input prices as given, they rent labor and capital in perfectly competitive factor markets so as to minimize real costs. This yields the optimal capital-labor ratio. In the second stage, each IG producer chooses a sequence of prices so as to maximize discounted real profits, subject to adjustment costs `a la Rotemberg (1982). The solution gives the adjustment process of the nominal price. The CG producer owns all the capital in the economy and uses a linear technology to produce capital goods. At the beginning of the period, it buys the final good from the FG producer. These goods must be paid in advance; to purchase final goods, the CG producer must borrow from the bank. At the end of the period, loans are paid in full with interest. Thus, the total cost of buying final goods for investment purposes includes the lending rate, iL. The CG producer t combinesinvestmentgoodsandtheexistingcapitalstocktoproduce new capital goods, subject to adjustment costs. The new capital stock is then rented to IG producers. The CG producer chooses the level of the capital stock (taking the rental rate, the lending rate, and the price of the final good as given) so as to maximize the value of the discounted stream of dividend payments (nominal profits) to the household. The first-order condition for maximization shows that the expected rental rate of capital is a function of the current and expected loan rates, the latter through its effect on adjustment costs in the next period. The commercial bank (which is owned by unconstrained house- holds)alsosuppliescredittoIGproducers,whouseittofinancetheir 202 International Journal of Central Banking September 2013 short-termworkingcapitalneeds.Itssupplyofloansisperfectlyelas- tic at the prevailing lending rate. To satisfy capital regulations, it issues nominal debt at the beginning of time t, once the level of (risky) loans is known.10 It pays interest on household deposits (at rate iD), the liquidity that it borrows from the central bank (at rate t iR), and its debt. The maturity period of both categories of bank t loans and the maturity period of bank deposits by unconstrained households is the same. In each period, loans are extended prior to activity (production or investment) and paid off at the end of the period. At the end of each period, the bank is liquidated and a new bank opens at the beginning of the next; thus, all its profits are distributed, bank debt is redeemed, and new debt is issued at the beginning of the next period to comply with prudential regulatory rules. Formally, and abstracting from required reserves and holdings of government bonds, the bank’s balance sheet is LF = D +V +LB, (2) t t t t where D is household deposits, LF total loans, LB borrowing from t t t the central bank (which covers any shortfall in resources), and V t total capital held by the bank, given by V = VR+VE, (3) t t t with VR denoting capital requirements and VE excess capital. t t Given that LF and D are determined by private agents’ behav- t t ior, the balance sheet constraint (2) can be used to determine bor- rowing from the central bank: LB = LF −D −V . (4) t t t t 10Thus, capital consists therefore, in the Basel terminology, solely of “supple- mentary”or“tier2”capital;thereisno“core”or“tier1”capital,thatis,ordinary shares.Inpractice,tomeetcapitalrequirements,bankshaveoftenissuedhybrid securitiesthataremorelikedebtthanequity.DatafromtheInternationalMon- etary Fund show that at the end of 2008 the average ratio of equity made up of issuedordinarysharestoassetswasonly2.5percentforEuropeanbanksand3.7 percent for U.S. banks. However, under the new Basel III regime, the definition of capital in terms of common equity has been considerably tightened.