Sectoral risk-weights and macroprudential policy

This paper analyses bank capital requirements in a general equilibrium model by evaluating the implications of different designs of such requirements in terms of their impact on the tendency of banks to amplify the business cycle. We compare the Basel-established Internal Ratings-Based (IRB) approach to risk weighting assets with an alternative macroprudential approach which sets risk-weights in response to sectoral measures of leverage. The different methods are compared in a crisis scenario, where the crisis originates from the housing market that affects the banking sector and is then transmitted to the wider economy. We investigate both the boom and bust phases of the crisis by simulating an unrealized news shock that leads to a gradual build-up and rapid crash in the economy. Our results suggest that the IRB approach creates procyclicality in regulatory capital requirements and thereby works to amplify both boom and bust phases of the financial cycle. On the other hand, our proposed macroprudential approach to setting risk-weights leads to counter-cyclicality in regulatory capital requirements and thereby attenuates the financial cycle.