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The Welfare Cost of Bank Capital Requirements

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  • Skander Van den Heuvel

    () (Finance Department University of Pennsylvania)

Abstract

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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Suggested Citation

  • Skander Van den Heuvel, 2005. "The Welfare Cost of Bank Capital Requirements," 2005 Meeting Papers 880, Society for Economic Dynamics.
  • Handle: RePEc:red:sed005:880
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    References listed on IDEAS

    as
    1. Giammarino, Ronald M & Lewis, Tracy R & Sappington, David E M, 1993. " An Incentive Approach to Banking Regulation," Journal of Finance, American Finance Association, vol. 48(4), pages 1523-1542, September.
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    6. Lucy White & Alan D. Morrison, 2002. "Crises and Capital Requirements in Banking," OFRC Working Papers Series 2002fe05, Oxford Financial Research Centre.
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    13. Miguel Sidrauski, 1967. "Inflation and Economic Growth," Journal of Political Economy, University of Chicago Press, vol. 75, pages 796-796.
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    More about this item

    Keywords

    Bank capital requirements; Welfare; Sidrauski model;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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