Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model

by Juliane Begenau

Overview — A central policy question is how to set capital requirements for banks. The author develops a model to study the effects of capital requirements on the economy and to determine the optimal level. Increasing the requirement to 14 percent from the current status quo leads to a reduction in bank debt, an increase in bank lending, and a reduction in the volatility of bank income. Indeed, policy makers and regulators have been seriously considering raising the capital requirement to 11.5 percent and thus closer to the optimal requirement implied by the quantitative model in this paper.

Author Abstract

This paper develops a quantitative dynamic general equilibrium model in which households' preferences for safe and liquid assets constitute a violation of Modigliani and Miller. I show that the scarcity of these coveted assets created by increased bank capital requirements can reduce overall bank funding costs and increase bank lending. I quantify this mechanism in a two-sector business cycle model featuring a banking sector that provides liquidity and has excessive risk-taking incentives. Under reasonable parameterizations, the marginal benefit of higher capital requirements related to this channel significantly exceeds the marginal cost, indicating that U.S. capital requirements have been sub-optimally low.

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