A General Equilibrium Appraisal of Capital Shortfall

Abstract

We quantify the capital shortfall that results from a global financial crisis by using a macro-finance dynamic stochastic general equilibrium model that captures the interactions between the financial and real sectors of the economy. We show that a crisis similar to that observed in 2008 generates a capital shortfall (or stressed expected loss, SEL) equal to 2.8% of euro-area GDP, which corresponds to approximately 250 billion euros. We also find that using a cycle-dependent capital ratio that combines concern for both credit growth and SEL has a positive effect on output growth while mitigating the excessive risk taking of the banking system. Finally, our estimates confirm that most of the variability of the macroeconomic and financial variables at business cycle frequencies is due to investment and risk shocks.