The Volatility Costs of Procyclical Lending Standards: An Assessment Using a Dsge Model

Abstract

The ongoing financial turmoil has triggered a lively debate onways of containing systemic risk and lessening the likelihood ofboom-and-bust episodes in credit markets. Particularly, it hasbeen argued that banking regulation might attenuateprocyclicality in lending standards by affecting the behavior ofbanks capital buffers. This paper uses a two-country DSGE modelwith financial frictions to illustrate how procyclicality inborrowing limits reinforces the �overreaction� of asset prices toshocks described by Aiyagari and Gertler (1999), and to quantifythe stabilization gains from policies aimed at smoothing cyclicalswings in credit conditions. Results suggest that, in financiallyconstrained economies, the ensuing volatility reduction in equityprices, investment, and external imbalances would be sizable. Inthe presence of cross-border spillovers, gains would be evenhigher.