Investigating the Impact of Bank Capital on Real Variables of an Oil Economy, Using the DSGE Model

Bank controllers and regulators have always focused on bank capital and capital adequacy rate as two important factors for sustaining and improving banking activities. In this research, we have tried to investigate the role of capital and the relations between the banking sector with the economic real variables. We also sought to study the impact of bank capital on the real sector of an economy, using the DSGE model. Accordingly, in this model, to comply with the facts of Iran's economy, we defined the capital adequacy rate based on Basel I and II standards and took into account the probability of default for the loans and facilities of the banks and firms endogenously. Meantime, since the banking sector plays a crucial role in the country’s economy, we tried to examine the relations between the banks and Iran Central Bank (CBI) as the regulator within Iran's economic ecosystem.

To examine the actions and reactions of key dynamics of the Iranian banking sector with the economic real variables, we used Dynamic Stochastics General Equilibrium (DSGE) model, by using quarterly modified data during 1996-2019.

The results of simulating the model in response to the bank capital increase and oil positive shock on the defined variables proved the designed model to be highly consistent with the theoretical expectations and the past experiences of Iran's economy. Furthermore, it was found that due to the increase in oil price and the positive balance of payment because of the increase in the oil income, bank loans could be increased. Therefore, by improving economic variables temporarily, oil positive shock would result in a decrease in the probability of default in banks, whilst increasing their profits. The results also indicated that the bank capital can be considered a key factor for evaluating real variables in Iran's economy by the CBI, so the increase in bank income would temporarily end in a decrease in GDP, because of different factors, including the cost of bank finance and the loan rate.

It can be concluded that capital plays an important role in the bank transition mechanism to society and the Central Bank can also play an important role in the process through applying the needed changes in the capital adequacy rate. Nevertheless, as the increase in the capital adequacy rate in the long term would decrease risk and improve banking activities, it would affect real variables during the transition period. Furthermore, any increase in liquidity and bank loans would decrease the real interest rates, affecting the economic variables positively. In addition, the effects of any increase in oil income can be shown in bank profit. Therefore, oil shock changes can be generalized to other economic real variables.