A theoretical foundation for prudential authorities’ decision-making

In the aftermath of the Global Financial Crisis, financial regulation uses micro and macroprudential rules based on fixed capital requirements ratios, most of the time motivated by empirical studies. This research, based on Badarau and Roussel (2022), provides a theoretical explanation for time-varying countercyclical capital requirements that incorporates micro- and macro-prudential stabilization objectives. We suggest that the Capital Adequacy Ratio imposed to individual banks by a Prudential Authority should be an optimal regulation that avoids individual and systemic risk accumulation by imposing minimal constraints to financial institutions.  We find an optimal time-varying prudential rule, with non-linear structure, that allows regulators to take progressive countercyclical actions in order to ensure financial stability. We also test the mechanism in a DSGE model and show that it would be more suitable for the financial and real stability compared to the existing fixed prudential ratios.