de ra l R es er ve B an k of C hi ca

Abstract This paper develops a new theory of bank capital requirements to provide insight into creditcycle stabilization and macro-prudential policy. A general equilibrium banking model is constructed in which deposit claims backed by bank assets support secured credit arrangements with limited commitment. The competitive equilibrium allocation is constrained-suboptimal because the asset market is imperfect when assets are useful for exchange with limited commitment. This paper shows that given aggregate risk, pro-cyclical capital requirements can improve economic welfare by trading off the opportunity cost of holding additional bank capital for the benefit from sharing liquidity risk. In the model bank capital requirements can influence real interest rates on assets and the inflation rate by adjusting the pledgeability of assets. Thus capital requirements can be an effective policy tool when the conventional monetary policy is limited to exchange liquid and illiquid assets.

A dynamic model with credit under limited commitment is constructed, in which limited memory can weaken the e¤ects of punishment for default. This creates an endogenous role for government debt in credit markets, and the economy can be non-Ricardian. Default can occur in equilibrium, and government debt essentially plays a role as collateral and thus im-proves borrowers incentives. The provision of government debt acts to discourage default, whether default occurs in equilibrium or not. These are our own views, and not necessarily those of the Federal Reserve Bank of St. Louis, or the Board of Governors of the Federal Reserve System. We thank seminar and conference participants at the Chicago Federal Reserve Bank Workshop on Money, Banking, and Payments, the 2012 SED Meetings, along with 3 anonymous referees and the editor Dimitri Vayanos, for their helpful comments and suggestions.