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JEL Classification:

E44, E47, E51, G21, G28

Abstract

We employ a micro founded and stock and flow consistent model in the tradition of Backus et al. (1980) to study the impact on the South African economy of a regulatory change raising banks’ leverage ratios. The model provides for a richer representation of institutional balance sheets than existing models. In it the financial sector’s behaviour parallels that analysed by Borio and Zhu (2012) and Woodford (2010), focussing attention on the relationship between bank capital, risk taking behaviour of the financial sector, lending spreads and economic activity. The financial accelerator mechanism operates through the balance sheets of all institutions in the economy. In line with the economic literature, the results indicate that the introduction of a higher leverage ratio for banks is likely to generate negative economic impacts in the short-run that depend on the banks’ choice of adjustment strategy. A negative GDP effect is greatest if the financial sector reduces leverage though a reduction in the value of its assets (for example, recall of loans) rather than the issue of new equity. The regulatory shock leads to the financial sector changing its perceptions of risk, which reduces the size of the money multiplier and increases lending spreads. The results also highlight that the higher regulatory requirements affect the transmission mechanisms of monetary policy. Effective execution of monetary policy requires understanding of how the financial sector is likely to achieve new regulatory requirements and how its perceptions of risk are affected.

Key words:

regulation, bank leverage ratio, money multiplier, South Africa, stock-flow consistent model