Liquidity Provision, Bank Capital, and the Macroeconomy

Abstract:     
Bank regulation has increasingly focused on capital requirements as the primary means of ensuring the "safety and soundness" of the banking system. We evaluate this policy approach by providing a theory of bank capital. Bank capital is beneficial because it reduces the chance of privately and socially costly bank failure. But it is both privately and socially costly because a system-wide increase in bank capital reduces the aggregate amount of bank deposits, which are an efficient medium of exchange, forcing consumers to hold more information-sensitive bank equity, which is a poor liquidity hedge. Recessions increase the risk and thus the information-sensitivity of bank equity, increasing the liquidity-related costs of additional bank capital. As a result, welfare-maximizing bank regulators may engage in "forbearance" ? that is, they may optimally renege on previously tough policies. Private incentives to increase capital are even smaller than social incentives, which may further limit regulators' ability to raise capital standards. Social and private reluctance to increase capital in a recession may in turn cause a "credit crunch."

Working Paper Series