1. International Monetary Fund and CESifo
Discussion of: “Capital Requirements in a Quantitative Model of Banking Industry Dynamics” by Dean Corbae and Pablo D’Erasmo (CD)
Gianni De Nicolò
International Monetary Fund and CESifo
The views expressed in this presentation are those of the author and do not necessarily represent those of the IMF.

2. CD contribution
This is an ambitious and important paper
It is (to the best of my knowledge) the first paper to deliver a quantitative model of a banking industry with heterogeneous banks
This is extremely useful for policy evaluation
My key comment: point estimates of “policy counterfactuals” need to be associated with estimates of uncertainty (errors) .

3. Key questions addressed by recent industry and general equilibrium models of banking
What is the quantitative impact of new Basel III capital requirements on:
Lending (and real activity)
Welfare
Most models have representative banks, no heterogeneity
CD introduce bank heterogeneity : this allows them to evaluate the impact of capital requirements on market structure (entry and exit) and competition.

4. Key features of the CD Model
Sequence of Stackelberg -Cournot equilibria, where the endogenous bank size distribution is obtained by adding entry/exit decisions.
The model is calibrated to match long-run averages of some banking industry statistics (the success is so far partial, see Table 5).
The introduction of bank heterogeneity comes at the unavoidable cost of several simplifications
Example: banks are owned by infinitely lived risk-neutral investors who discount future cash flows at an exogenous rate (no financial market equilibrium).

5. Quantitative impact of increased capital requirements on lending
Recent equilibrium models generate a broadly consistent qualitative picture of the (long-term) impact of an increase in capital requirements on lending and real activity:
Capital requirements reduce bank risk
lending and real activity decline
there exists an inverted-U shaped relationship between bank lending, welfare, and capital requirements.
Yet, quantitative assessments differ substantially.

6. How can we compare these quantitative results? Models are not nested

7. The closest model comparable to CD
De Nicolò, Gamba and Lucchetta ( DNGL, RFS 2014)
Banks dynamically transform short term liabilities into longer-term illiquid assets whose returns are uncertain (no maturity transformation in CD, but equilibrium loan rates in CD and not in DNGL) .
Deposits are insured (as in CD)
Banks can be in financial distress, can issue debt or equity with issuance costs (as in CD)
Financial market equilibrium, endogenous discount factor (not in CD)
Pricing of systematic (aggregate) and idiosyncratic risks, large set of states on a truncated normal grid ( 2 aggregate states in CD)
Calibration based on US data (as in CD)
Value metrics of bank efficiency and welfare (not in CD)

8. How capital and associated liquidity choices move along the business cycle?
CD: Loan supply is pro-cyclical (as in DNGL).
(DNGL) Under mild capital requirements, banks buildup capital buffers in upturns to reduce the risk of costly loan liquidations in downturns , but ratios decline (as in CD, Figure 18)
(DNGL) In a downturn banks use retained earnings and the financial resources freed by the reduction in lending to strengthen their liquidity position (as in CD, p.39).
CD: the correlation between fringe bank capital ratios is lower than that of the big banks, but stats of model and data do not match well yet

9. An increase in capital requirements: the competitive effects
Important CD results:
Exit rates decline for fringe banks. The leader bank reduces loan supply and induces entry of small banks, but charter value declines dominate, reducing the size of the fringe bank sector  increase in concentration
On net: lower loan supply (-8.7%), increase in interest rates (+7.6)% and corporate default frequencies (+12.2%)
Yet, the reported numbers seem fairly large. How robust are these quantitative results to the calibration procedure?

10. Some observations on the model
The model is very stylized in several dimensions
No maturity transformation (a key role of banks)
Competition: the US banking industry is treated as a perfectly integrated one (no segmentation): is the Stackelberg-Cournot model the right one?
Is welfare analysis feasible in this framework?

11. Concluding remarks
An ambitious paper with a long list of potentially useful extensions (Several papers, too much stuff in one only!)
The key issue is however: how much confidence can we place on the quantitative results?
My suggestions:
1. Given a “baseline” model, provide a method to measure the errors associated with any estimate of policy counterfactual (at a minimum, extensive robustness analysis)
2. Harmed with such a method, richer versions of the model might allow comparisons of policy counterfactuals evaluated across nested models

12. References
Begenau, Juliane, 2015, Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model, Harvard Business School Working Paper, No , March.
 Clerc, Laurent, Alexis Derviz, Caterina Mendicino, Stephane Moyen, Kalin Nikolov, Livio Stracca, Javier Suarez, Alexandros P. Vardoulakis, 2014, Capital Regulation in a Macroeconomic Model with Three Layers of Default, forthcoming in the International Journal of Central Banking
De Nicolò Gianni, Andrea Gamba, and Marcella Lucchetta, 2014, Microprudential Regulation in a dynamic model of banking, Review of Financial Studies, Vol. 27, 7,
 Martinez-Miera, D. and J. Suarez (2014). Banks' endogenous systemic risk taking. Working paper.
 Nguyen, Thien Tung, 2014, Capital Requirements: A Quantitative Analysis, mimeo,