Discussion Paper

No. 2016-27 | June 23, 2016
Prudential Regulation in an Artificial Banking System

Abstract

This study constitutes an exploratory analysis of the economic role of banks under different prudential frameworks. It considers an agent-based computational model populated by consumers, firms, banks and a central bank whose out-of-equilibrium interactions replicate the conjunct dynamics of a banking system, a financial market and the real economy. A calibrated version of the model is shown to provide an intelligible account of several recurrent economic phenomena and it can be a privileged ground for policy analysis. The authors’ investigation provides a relevant methodological contribution to the field of banking research and sheds new light into the role of banks and their prudential regulation. Specifically, the results suggest that banks are key economic agents. Through their financial intermediation activity, credit institutions facilitate investment and promote growth.

JEL Classification:

C63, G28

Assessment

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Links

Cite As

José Dias Curto and Pedro Dias Quinaz (2016). Prudential Regulation in an Artificial Banking System. Economics Discussion Papers, No 2016-27, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2016-27


Comments and Questions


Anonymous - comment
June 24, 2016 - 23:49

good article


Carlos Pedro Gonçalves, University of Lisbon - Invited Reader Report
July 18, 2016 - 08:31

Computational economics is a fast growing field of research, a growth that is characterized by two main lines:

- Machine learning incorporated in economic and financial data analysis and in economic and financial decision making support systems;
- Agent-based modeling of economic and financial systems.

The work by José ...[more]

... Dias Curto and Pedro Miguel Quinaz focuses on the later and applies it to policy-making.

The application of agent-based modeling to Economics comes mainly from the 1980s and 1990s Complexity Sciences research. The underlying paradigm was established by the Santa Fe Institute (SFI)’s research on the “Economy as an Evolving Complex System”, title of the 1988 book that contained the proceedings from the 1987 workshop “Evolutionary Paths of the Global Economy” sponsored by the SFI.

The development of the research on Complex Systems during the 1990s, thus, led to the expansion of a new way of building economic theory which incorporated artificial life and artificial intelligence to build simulation models of economic systems, that is: the economist builds artificial economic systems to study economic dynamics and how economic relations, decision rules and learning can make emerge certain macroscopic patterns and dynamics.

The article by José Dias Curto and Pedro Miguel Quinaz argues in favor of the application of agent-based modeling not only as a tool to study economies but also as a possible tool for economic and financial policy-making, namely, article focuses on policies regarding banking micro-prudential regulations and macro-prudential policies. In this sense, the work makes a relevant contribution for public policies by applying the methodology of agent-based modeling for policy research, in this case, directed towards the banking sector.

The model built and tested by the authors addresses the relation between banks and economic performance, including the role and importance of banks for the economy, so that different prudential frameworks can be tested in regards to their effects on both banking and economic performance. In this way, the article links banking regulation and financial risk policies to economic policy.

The model allows the authors to evaluate in a simplified economy comprised of companies, consumers and banks, how different micro-prudential regulations affect economic growth and how macro-prudential policies may affect financial stability.

The model works with two production factors: labor and capital, so that consumers provide labor and receive compensation from companies. There is a single consumption asset economy, thus, the consumers allocate their income in terms of savings and consumption of the asset. The production level of companies, which determines the supply is based on the companies’ production capacity and expectations of demand. Economic equilibrium is not assumed, so that there may be excess supply or excess demand.

Companies also invest in infrastructures and technology, increasing their productivity. In regards to productivity and labor, the model assumes a simplified structure: the labor is fixed. Which means that economic crises, banking failure and companies extinctions, or more complex technology-induced unemployment with consequences in demand and supply relations is not developed. A specific effect on the relation between salaries and demand is, however, introduced by the authors in the possibility of delayed wages.

The only source of investment financing for companies besides equity financing is banking loans. Banks receive deposits and grant credit in the form of loans.

In the resulting artificial economy, built by the authors, a few relevant policy-making results are achieved:

- Stricter capital requirements affect, in the artificial economy, negatively aggregate economic performance due to credit rationing;
- Credit availability, as long as it is not excessive, prevents the depletion of financing for companies and reduces the companies’ bankruptcy risk;
- Stricter capital requirements do not always lead to a reduction of bank defaults due to the impact it has on the profitability levels of banks;
- Counter-cyclical prudential tools are ineffective in the artificial economy.

Albeit presenting a simplified model of economic and financial relations, the article makes an important contribution for prudential policy-making in the sense that it links the effectiveness assessment of prudential policies to a specific structure in economic and banking relations. The artificial economy developed by the authors also has room to grow, including the possibility of the introduction of a more complex labor market, taxes, public finance, a more complex artificial financial market, technological innovation and its effects in the industry and in employment, all factors that may affect the end-performance of the banks as well as the performance of the economy.


Anonymous - Referee Report 1
July 19, 2016 - 13:07

See attached file


José Dias Curto and Pedro Miguel Mateus Dias Quinaz - Reply to Referee Report 1
July 27, 2016 - 10:41

see attached file