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The Welfare Cost of Bank Capital Requirements

  • Skander Van den Heuvel

    ()

    (Finance Department University of Pennsylvania)

Capital requirements are the cornerstone of modern bank regulation, yet little is known about their welfare cost. This paper measures this cost and finds that it is surprisingly large. I present a simple framework, which embeds the role of liquidity creating banks in an otherwise standard general equilibrium growth model. A capital requirement limits the moral hazard on the part of banks that arises due to deposit insurance. However, this capital requirement is also costly because it reduces the ability of banks to create liquidity. The key insight is that equilibrium asset returns reveal the strength of households' preferences for liquidity and this allows for the derivation of a simple formula for the welfare cost of capital requirements that is a function of observable variables only. Using US data, the welfare cost of current capital adequacy regulation is found to be equivalent to a permanent loss in consumption of between 0.1% and 1%.

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Paper provided by Society for Economic Dynamics in its series 2005 Meeting Papers with number 880.

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Date of creation: 2005
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Handle: RePEc:red:sed005:880
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  1. Lucy White & Alan D. Morrison, 2002. "Crises and Capital Requirements in Banking," OFRC Working Papers Series 2002fe05, Oxford Financial Research Centre.
  2. Giammarino, R.M. & Sappington, D.E.M., 1990. "An Incentive Approach to Banking Regulation," Papers 367, California Davis - Institute of Governmental Affairs.
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  4. Allen, Franklin & Carletti, Elena & Marquez, Robert, 2005. "Credit market competition and capital regulation," CFS Working Paper Series 2005/23, Center for Financial Studies (CFS).
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  8. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
  9. Jones, David, 2000. "Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 35-58, January.
  10. Douglas W. Diamond & Raghuram G. Rajan, . "A Theory of Bank Capital," CRSP working papers 363, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  11. Repullo, Rafael & Suarez, Javier, 2003. "Loan Pricing Under Basel Capital Requirements," CEPR Discussion Papers 3917, C.E.P.R. Discussion Papers.
  12. Miguel Sidrauski, 1967. "Inflation and Economic Growth," Journal of Political Economy, University of Chicago Press, vol. 75, pages 796.
  13. Alan D. Morrison & Lucy White, 2005. "Crises and Capital Requirements in Banking," American Economic Review, American Economic Association, vol. 95(5), pages 1548-1572, December.
  14. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  15. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
  16. Mathias Dewatripont & Jean Tirole, 1994. "The prudential regulation of banks," ULB Institutional Repository 2013/9539, ULB -- Universite Libre de Bruxelles.
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