The Foreign Liability Channel of Bank Capital Requirements
We examine the effects of tighter capital requirements in a quantitative model with banks exposed to solvency risk and foreign liabilities. Setting bank capital requirements at appropriately high levels is essential to enhance the resilience of banks against sudden losses and the risk of insolvency.
Authors:
- Luigi Falasconi
- Pablo Herrero
- Caterina Mendicino
- Dominik Supera
Abstract
We examine the effects of tighter capital requirements in a quantitative model with banks exposed to solvency risk and foreign liabilities. Setting bank capital requirements at appropriately high levels is essential to enhance the resilience of banks against sudden losses and the risk of insolvency.
However, a reduction in bank solvency risk in turn also helps banks to increase their reliance on foreign liabilities, leading to a novel trade-off of bank capital regulation in open economies.
Higher capital requirements make banks, and the economy as a whole, more resilient to shocks originating in the banking sector, while at the same time increasing their exposure to a sudden reduction in banks’ availability of foreign funds.
Our results suggest that in the presence of bank solvency risk, foreign exchange rate interventions are complementary to bank capital requirements in addressing financial vulnerabilities.
Estimates using bank-level data on Peru’s transition to higher capital requirements lend support to the foreign liability channel of bank capital requirements.