Capital Requirements in a Financially Driven Business Cycle Model

We consider a simple overlapping generations economy where, because of asymmetric information and limited liability both in the loan and the deposits markets, firms have the incentive to undertake less efficient investment projects, while intermediaries have the incentive to monitor a smaller number of firms. Because of the positive relationship between the deposit interest rate and the level of monitoring, the lending activity of intermediaries may cause endogenous fluctuations in the level of economic activity.
In this economy, a higher capital requirement, introduced to render deposit contracts incentive compatible, implies a higher steady state stock of capital, fewer bankruptcies among intermediaries and smaller fluctuations in the level of economic activity.
(J.E.L. E32, D82, G28)