The Effects of Capital Requirements on Good and Bad Risk-Taking

Abstract

We study capital requirement regulation in a dynamic quantitative model in which nonfinancial firms, as well as households, hold deposits. A novel general equilibrium
channel that operates through firms’ deposits mitigates the cost of increasing capital requirements. In the calibrated model, (i) the optimal capital requirement is 7.3 percentage points higher than in a comparable model in which all the deposits are held by households, and (ii) setting the capital requirement higher than the true optimum is not as costly as one would gauge from the comparable model. We also provide some independent evidence that supports our novel channel.

Keywords: Capital Requirements, Deposit Insurance, Idiosyncratic Risk, Safe Assets, Firms' Cash Holdings

JEL Classification: E21, G21, G32