Discussion Paper Series 2020-E-3

Welfare Implications of Bank Capital Requirements under Dynamic Default Decisions

Toshiaki Ogawa

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.

Keywords: Bank capital requirements; Occasionally binding constraints; Endogenous default; Entry and exit; General equilibrium model

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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