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Welfare Implications of Bank Capital Requirements under Dynamic Default Decisions

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  • Toshiaki Ogawa

    (Deputy Director and Economist, Institute for Monetary and Economic Studies, Bank of Japan (E-mail: toshiaki.ogawa@boj.or.jp))

Abstract

This paper studies capital requirements and their welfare implications in a dynamic general equilibrium model of banking. I embed two, less commonly considered but important, mechanisms. Firstly, banks choose entry and exit, which lets the number of banks change endogenously. Strengthening capital requirements reduces banks' franchise value and damages their liquidity providing function through the extensive margin. Secondly, since equity issuance is costly for banks, they precautionarily hold capital buffers against future liquidity shocks. This behavior makes present capital requirements only occasionally binding. My model shows that the optimal capital requirement would be lower than that in the literature because of the expanded negative effects of capital requirements. To maintain financial stability without damaging banks' liquidity provision, strengthening capital requirements needs to be accompanied by reducing the cost of equity issuance for banks.

Suggested Citation

  • Toshiaki Ogawa, 2020. "Welfare Implications of Bank Capital Requirements under Dynamic Default Decisions," IMES Discussion Paper Series 20-E-03, Institute for Monetary and Economic Studies, Bank of Japan.
    • Handle: RePEc:ime:imedps:20-e-03
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    File URL: https://www.imes.boj.or.jp/research/papers/english/20-E-03.pdf
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    More about this item

    Keywords

    Bank capital requirements; Occasionally binding constraints; Endogenous default; Entry and exit; General equilibrium model;
    All these keywords.

    JEL classification:

    • E00 - Macroeconomics and Monetary Economics - - General - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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