We explore the ability of a macroprudential policy instrument to dampen the consequences of equity mispricing (a bubble) and the correction thereof (the bubble bursting), as well as the consequences for real activity in a production economy. In our model, producers are financed by both bank debt and equity, and face a mix of systemic and idiosyncratic uncertainty. Positive/negative bubbles arise when prior public beliefs about the aggregate productivity of producers (business sentiment) become biased upwards/downwards. Economic activity in equilibrium is influenced by the bubble size in conjunction with agency problems caused by delegation of lending to relationship bankers. The presence of macroprudential policy is manifested in a convex dependence of bank capital requirements on the quantity of uncollateralized credit. We find that this kind of policy is more successful in suppressing equity price swings than moderating output fluctuations. At the same time, economic activity recoils substantially with the introduction of a macroprudential instrument, so that its presence is likely to entail tangible welfare costs. In this regard, fine-tuning capital charges as a function of corporate governance on the borrower side (specifically, by discouraging limited liability of borrowing firm managers) would be less costly than placing the full burden of prudential regulation on the lender side.
JEL Codes: G01, G21, G12, E22, D82
Keywords: Asset price, bank, bubble, credit, macroprudential policy
Issued: August 2011
Download: CNB WP No. 4/2011 (pdf, 331 kB)
Published as: Derviz, A. (2011): Real Implications of Bursting Asset Price Bubbles in Economies with Bank Credit. Czech Journal of Economics and Finance, 61(1), 92–116