Welfare analysis of bank capital requirements with endogenous default

This paper presents a tractable framework with endogenous default and evaluates the welfare implication of bank capital requirements. Using a dynamic general equilibrium model we analyze the social welfare response to a negative technology shock under different capital requirement regimes, Basel II and III. In Basel III, we consider alternative indicators, such as output gap and credit-to-output gap. We then consider the scenario where the default rate is augmented in different capital requirement regimes. We show that it is welfare improving by including the default rate as an additional indicator for all capital requirement regimes. A more aggressive reaction to default can effectively mitigate the negative effect of the shock on welfare and this attenuation effect works through the bank funding channel.