We develop a dynamic stochastic general equilibrium model with an heterogeneous banking
sector. We introduce endogenous default probabilities for both firms and banks, and
allow for bank regulation and liquidity injection into the interbank market. Our aim is to
understand the interactions between the banking sector and the rest of the economy, as well
as the importance of supervisory and monetary authorities to restore financial stability. The
model is calibrated against real US data and used for simulations. We show that Basel regulation
reduces the steady state but improves the resilience of the economy to shocks, and
that moving from Basel I to Basel II is procyclical. We also show that liquidity injections
relieve financial instability but have ambiguous effects on output fluctuations.
 
Joint paper with Gregory deWalque (National Bank of Belgium and University of Namur) and
Abdelaziz Rouabah (Central Bank of Luxembourg), January 2009