Benefits and Costs of Higher Capital Requirements for Banks

This study provides new estimates of the likely economic losses from banking crises. It also provides new estimates of the economic cost of increasing bank capital requirements, based on the author's earlier estimate (Cline 2015) of the empirical magnitude of the Modigliani-Miller effect in which higher capital reduces unit cost of equity capital. The study applies previous official estimates (BCBS 2010a) of the impact of higher capital on the probability of banking crises to derive a benefits curve for additional capital, which is highly nonlinear. The benefit and cost curves are examined to identify the socially optimal level of bank capital. This optimum is estimated at about 7 percent of total assets, with a more cautious alternative (75th percentile) at about 8 percent, corresponding to about 12 and 14 percent of riskweighted assets, respectively. These levels are, respectively, about one-fourth to one-half higher than the Basel III capital requirements for the large global systemically important banks (G-SIBs).