The Effects of Countercyclical Capital Rules on Banking Stability and Macroeconomic Dynamics in Iran

T The financial soundness indicators reveal the significant signs of distress in the Iranian banking sector. An important question is whether the implementation of the countercyclical capital requirement rules in the form of the Basel III type-rules increases the stability of the banking sector in Iran. The literature on macroprudential policy in Iran lacks a model to study the effects of the countercyclical capital requirements rules on the ratio of capital to loans as an important indicator of the soundness of the banking sector in the presence of an adverse supply shock. Moreover, no study has investigated the impact of this macroprudential policy tool on the dynamics of consumption and investment in Iran. To fill these gaps, we develop and estimate a New Keynesian dynamic stochastic general equilibrium (DSGE) model. The model is estimated by the Bayesian method for three different capital requirements rules, namely (1) the constant capital requirements, (2) the countercyclical capital requirements rule that reacts to the ratio of loans to output, and (3) the countercyclical capital requirements rule that responds to economic growth. The results show that when a negative supply shock hits the economy, the implementation of the countercyclical capital requirements rule reduces the instability of the banking sector in Iran. Moreover, we find that the model with the countercyclical capital requirements rules results in more stable output, inflation, consumption, and investment. Furthermore, our results suggest that the countercyclical capital rule that reacts to economic growth enhances banking stability in Iran. These findings might have important policy implications for policymakers when implementing macroprudential policies in Iran.