Nancy Seminar – Lisa Kerdelhué (Banque de France)

Abstract: This paper enquires the extent to which banks’ capital requirements enable to ensure the resilience of the economy in a context of monetary tightening. We build a new Keynesian model, featuring costly defaults for banks, households and firms, and estimate it on Euro Area data between 2003 and 2019. We then investigate the propagation of a cost-push shock along financial variables and according to two scenarios: a standard monetary normalization and a hard landing. We show that both scenarios are likely to severely affect the economy. We then compute optimal capital requirements. We show that optimal capital requirements do not interfere with monetary policy in case of a standard normalization, while having reached the optimal target enables to considerably alleviate the effects of a hard landing if interest rate risks are born by banks. This means that capital requirements are complementary to monetary policy, in so far that they give more room to the monetary authority.