We use an incentive model in which improvements to fundamentals boost the ability of leveraged financial firms (banks) to expand the balance sheet (as in Adrian and Shin 2010). The rise in asset prices due to the amplified response of procyclical systems distorts bankers' incentives in providing (costly and non observable) monitoring effort. On the one hand, the fundamental value of assets positively affects the optimal effort of the banker, thus allowing supervisory authorities to relax incentive-compatible capital requirements and boosting asset demand and prices. On the other hand, in a macro perspective, high prices positively affect the banker's payoff in the bad state of asset liquidation (via asset prices), jeopardizing incentives. This type of externality follows from a purely “macro” phenomenon à la Borio (2003) and should be taken into account by the regulatory authority in designing capital requirements. In procyclical and advanced (low agency costs and highly liquid) financial systems, incentive compatibility requires a higher capital requirement in the face of an improvement to fundamentals. Our results provide a theoretical foundation to the countercyclical buffer provided for by the Basel Committee.
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