The new banking regulation in Basel III: welfare effects and optimal implementation

In this paper, we take as a baseline a dynamic stochastic general equilibrium (DSGE) model, which features a housing market and a financial intermediary, in order to evaluate the welfare and macroeconomic effects of the new banking regulations in Basel III. We analyze the increase in capital requirements as well as the counter-cyclical capital buffer that the new regulation implies. To incorporate this buffer, we propose a macroprudential rule in which capital requirements respond to credit growth, output and housing prices. We find that the optimal implementation of Basel III is counter-cyclical for borrowers and banks, the agents directly affected by capital requirements, while pro-cyclical for savers. From a normative perspective, we see that the macroprudential component of Basel III delivers higher welfare for the society than a situation with no regulation.