The System-Wide Effects of Bank Capital Regulation on Credit Supply and Risk-Taking
University of Chicago - Finance
Christian C. Opp
University of Pennsylvania - The Wharton School
Marcus M. Opp
University of California, Berkeley - Finance Group
October 14, 2015
We propose a tractable framework to examine the system-wide effects of bank capital requirements. In our model, banks can serve a socially beneficial role by financing firms that are credit rationed by public markets, but banks' access to deposit insurance (and implicit debt guarantees) creates socially undesirable risk-shifting incentives. Equity ratio requirements reduce banks' risk-taking incentives, but may also constrain banks' balance sheets. When existing bank capital is sufficiently high, increases in equity-ratio requirements unambiguously improve welfare and the stability of the banking system. However, when bank capital is scarce, increased equity-ratio requirements induce credit rationing of both bank-dependent firms with positive NPV projects and risky firms with negative NPV. In this case, the net effects on welfare and the risk-taking of banks are ambiguous, as they depend on which type of credit rationing dominates. Our model provides conceptual guidance on the cyclicality of optimum capital requirements as well as their dependence on the development of public markets and the cross-sectional distribution of firms.
Number of Pages in PDF File: 24
Keywords: capital requirements, credit supply, bank-dependent firms, macroprudential regulation, banks, competition, public capital markets
JEL Classification: G21, G28
Date posted: July 19, 2014 ; Last revised: October 28, 2015
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