Macroeconomic Dynamics of Market Risk Capital Requirements and Credit Supply Interdependence

The 2008 global financial crisis revealed serious weaknesses in the worldwide banking system and financial regulatory regime. Concerns arose about the possible procyclical effects of risk-sensitive capital requirements that rely on Value-at-Risk (VaR) for managing market risks. The first chapter of this dissertation begins with a brief history of the Basel Committee on Banking Supervision, its contribution in designing capital requirements, and some basic examples to illustrate how VaR contributes to the procyclicality of bank leverage and its amplification effects on financial markets. It then reviews the importance of financial factors, such as leverage and risk, on the business cycle and how the macroeconomic literature has attempted to account for these factors.;The second and third chapters analyze how market risk-sensitive capital requirements can affect credit supply and amplify business cycles. These requirements effectively risk-constrain leveraged financial institutions and induce feedback effects on the macroeconomy when banks adjust their balance sheets to comply with these capital requirements. The second chapter analyzes the procyclical effects of Basel II's VaR-based capital requirements within a fully dynamic general equilibrium macroeconomic model with a financial sector. The model is calibrated to U.S. data and estimated with Bayesian techniques to pin down the dynamics and is able to capture four important business cycle correlations between financial factors and macroeconomic activity. The results suggest that when leveraged financial institutions are constrained by VaR-based capital requirements, increased financial market volatility forces banks to adjust their balance sheets to comply with higher capital charges by selling assets at reduced prices. This action depletes bank capital and deteriorates risk-weighted balance sheet positions, raising their perceived probability of default and interbank borrowing costs. Ultimately, these effects restrict the financial sector's ability to supply credit to the productive sectors to finance investment. Additionally, if financial markets become illiquid and banks are unable to sell assets and violate their risk constraints, the effects become amplified. These results provide some rationale for the Federal Reserve taking on the buyer of last resort role in the asset-backed securities market during the 2008 financial crisis. Thus, credit supply and market risk capital requirements are shown to be interdependent through risk constraints.;The third chapter analyzes how Basel III's proposed switch from Value-at-Risk to stressed Conditional Value-at-Risk (CVaR) to measure market risks might affect the procyclicality of bank risk constraints on the macroeconomy. CVaR may reduce the spillover effects of market risk-sensitive capital requirements on credit supply and aggregate investment compared to the current VaR regime if regulation abandons the efficient markets hypothesis in favor of the fractal markets hypothesis and calibrates risks to stressed market conditions. Stressed CVaR can reduce banks' balance sheet response to increases in perceived volatility, which should reduce the risk-constrained feedback effects as banks are forced to comply with increased capital charges. However, because asset returns are generally non-normally distributed, if CVaR is locally calibrated to current market conditions it may amplify these effects in response to changes in perceived tail risks. These results provide some supporting evidence for Basel III's proposed stressed CVaR market risk regime.