Sudden floods, macroprudential regulation and stability in an open economy

•Builds a small open economy DSGE model with a two-level banking structure.•Also with a risk-sensitive regulatory capital regime and imperfect capital mobility.•Capital flows generate an expansion in credit and activity, and asset price pressures.•Countercyclical capital requirements promote economic stability.•But they may need to be supplemented by more targeted macroprudential instruments.

A dynamic stochastic model of a small open economy with a two-level banking intermediation structure, a risk-sensitive regulatory capital regime, and imperfect capital mobility is developed. Firms borrow from a domestic bank and the bank borrows on world capital markets, in both cases subject to a premium. A sudden flood in capital flows generates an expansion in credit and activity, as well as asset price pressures. Countercyclical capital regulation, in the form of a Basel III-type rule based on credit gaps, is effective at promoting macro stability (defined in terms of the volatility of a weighted average of inflation and output deviations) and financial stability (defined in terms of three measures based on asset prices, the credit-to-GDP ratio, and the ratio of bank foreign borrowing to GDP). However, because the gain in terms of reduced economic volatility exhibits diminishing returns, in practice a countercyclical regulatory capital rule may need to be supplemented by other, more targeted macroprudential instruments when shocks are large and persistent.