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Regulation and Rational Banking Bubbles in Infinite Horizon

Author

Listed:
  • Claire Océane Chevallier

    (CREA, Université du Luxembourg)

  • Sarah El Joueidi

    (CREA, Université du Luxembourg)

Abstract
This paper develops a dynamic stochastic general equilibrium model in infinite horizon with a regulated banking sector where stochastic banking bubbles may arise endogenously. We analyze the conditions under which stochastic bubbles exist and their impact on macroeconomic key variables. We show that when banks face capital requirements based on Value-at- Risk, two different equilibria emerge and can coexist: the bubbleless and the bubbly equilibria. Alternatively, under a regulatory framework where capital requirements are based on credit risk only, as in Basel I, bubbles are explosive and, as a consequence, cannot exist. The stochastic bubbly equilibrium is characterized by positive or negative bubbles depending on the tightness of capital requirements based on Value-at-Risk. We find a maximum value of capital requirements under which bubbles are positive. Below this threshold, the stochastic bubbly equilibrium provides larger wel- fare than the bubbleless equilibrium. In particular, our results suggest that a change in banking policies might lead to a crisis without external shocks.

Suggested Citation

  • Claire Océane Chevallier & Sarah El Joueidi, 2016. "Regulation and Rational Banking Bubbles in Infinite Horizon," DEM Discussion Paper Series 16-15, Department of Economics at the University of Luxembourg.
    • Handle: RePEc:luc:wpaper:16-15
    as

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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Banking bubbles; banking regulation; DSGE; infinitely lived agents; multiple equilibria; Value-at-Risk;
    All these keywords.

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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