The Effects of Countercyclical Capital Buffers on Macroeconomic and Financial Stability

We quantitatively study the effectiveness of several forms of countercyclical capital buffers on promoting macroeconomic and financial stability. To do this we introduce banks and a regulatory capital requirement rule to an open economy DSGE model. The capital requirement consists of a fixed part and a countercyclical part. We find that the tighter fixed capital requirements, the better able banks are to handle a financial crisis, but these also reduce long-term consumption and welfare. More importantly, countercyclical buffers that respond to deviation of the observed credit to GDP ratio from its long-term value, or to percentage deviation of the observed credit (or GDP) from its long-term value improve macroeconomic and financial stability and increase welfare. Being forward looking does not pay off. Interestingly, when buffers respond to percentage deviation of asset prices from their long-term values or to credit (or GDP) growth, macroeconomic and financial stability are negatively affected.