The Welfare Cost of Bank Capital Requirements

This paper measures the welfare cost of bank capital requirements 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 plays a role, as it limits the moral hazard on the part of banks that arises due to the presence of a deposit insurance scheme. However, this capital requirement is also costly because it reduces the ability of banks to create liquidity. A key result 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 U.S. data, the welfare cost of current capital adequacy regulation is found to be equivalent to a permanent loss in consumption of between 0.1 to 1 percent. 1 Finance Department, Wharton School, 3620 Locust Walk, Philadelphia, PA 19104, USA. Email: [email protected]. The author especially thanks Andy Abel and Joao Gomes for detailed comments and suggestions, as well as Franklin Allen, John Boyd, Marty Eichenbaum, Gary Gorton, Stavros Panageas, Amir Yaron and seminar participants at the FDIC, the Federal Reserve Board, the Federal Reserve Banks of Philadelphia and San Francisco, the NBER Summer Institute, the Society for Economic Dynamics and Wharton, for helpful suggestions. Sungbae An, Itamar Drechsler and Nicolaas Koster provided excellent research assistance. All mistakes are mine.