The Importance of Being Slow - The Costs and Benefits of Phasing-In Regulatory Reforms
We build a stylized dynamic equilibrium model with financial frictions to study how capital requirements affect the dynamics of aggregate bank lending. A sudden regulatory tightening may cause substantial issuance of bank capital, but also a severe credit crunch. When the regulatory tightening is introduced with a transition period, the anticipation of larger profits from lending induces banks to retain more earnings during the transition phase. This accelerates the accumulation of capital buffers and reduces the risk of a credit crunch. In line with recent empirical evidence, lending can increase in response to the announcement of a regulatory tightening.