This document summarizes a thesis that examines whether varying bank capital requirements could reduce the likelihood of financial crises. The thesis uses a macroeconomic model to simulate the effects of positive productivity and optimism shocks on key economic variables. It then simulates whether adjusting bank capital requirements or other policies could reduce asset price inflation in response to these shocks. The simulations find that policy responses in general mitigate asset price inflation compared to no response, but varying bank capital requirements is less effective than other policies, especially for permanent productivity shocks or temporary optimism shocks.

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Would Variable Bank Capital Requirements Reduce the
Likelihood of Financial Crises?
Alison Lim*
ABSTRACT
Asset price inflation seems to always precede financial crises which leads to
significant consequences to the economy. Key variables that are affected suffer
large losses in wealth and income which lead to rising unemployment. In this
thesis, we discuss the role of banks in facilitating asset pricing bubbles and
therefore asset price inflation in the stock market. We adopt and modify a small
scale macro model by Wells (2010) and Romer (2000) with proposed
parameters and simulations for each equation. Further, we simulate the various
time paths of key variables in our model to show the effect of a permanent
positive productivity shock and another shock as a proxy for an increase in
optimism on stock prices. In each instance, we conduct simulations on whether
varying bank capital requirements would reduce asset price inflation, versus
other policy responses or no policy response being made, each time with
varying levels of the policy’s aggressiveness. We find that policy responses
mitigate asset price inflation compared to no policy response being made.
Moreover, varying bank capital requirements is less effective than expected in
combating asset price inflation when there is a permanent productivity shock to
the economy and less effective when there is a temporary increase in optimism
of stock prices.
*University of Technology, Sydney (UTS). Correspondence: Alison.l.lim@gmail.com