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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
Date of revision:
Handle: RePEc:red:sed005:880
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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