A previous version of this working paper was originally published as Time-Varying Capital Requirements in a General Equilibrium Model of Liquidity Dependence in September 2009.

At the center of this problem is the interaction between entrepreneurs' moral hazard and liquidity provision by banks, as analyzed by Holmstrom and Tirole (1998). The authors impose capital requirements under the assumption that raising funds through bank equity is more costly than through deposits. They consider the time-varying capital requirement (as in Basel II) as well as the constant requirement (as in Basel I). Importantly, under both regimes, the cost of issuing equity is higher during downturns. Comparing output fluctuations under the Basel I and Basel II economies with those in the no-requirement economy, the authors show that capital requirements significantly contribute to magnifying output fluctuations. The procyclicality is most pronounced around business cycle peaks and troughs.