Leverage restrictions in a business cycle model
We seek to develop a business cycle model with a financial sector which can be used to study the consequences of policies to restrict the leverage of financial institutions (banks). Because we wish the model to be consistent with basic features of business cycle data we introduce our banking system into a standard medium sized DSGE model such as Christiano Eichenbaum and Evans (2005) (hereinafter CEE) or Smets and Wouters (2007). Banks in our model operate in perfectly competitive markets. Our model implies that social welfare is increased by restricting bank leverage relative to what leverage would be if financial markets were unregulated. With less leverage banks are in a position to use their net worth to insulate creditors in case there are losses on bank’s balance sheets. Our model implies that by reducing risk to creditors agency problems are mitigated and the efficiency of the banking system is improved.