Dynamic Bank Capital Requirements

Abstract

Basel III requires countercyclical capital buffers to protect the banking system from periods of excessive credit growth and leverage buildup. In this paper, I provide a rationale for time-varying capital requirements in a dynamic general equilibrium setting. An optimal policy trades off reduced inefficient lending with reduced liquidity provision. Quantitatively, I find that the optimal Ramsey policy requires a capital ratio that mostly varies between 5% and 7% and depends on economic growth, bank credit, and asset prices. The welfare gain from implementing this dynamic policy is large when compared to the gain from having an optimal fixed capital requirement.

Keywords: Capital requirements, Ramsey policy, bank credit, liquidity provision

JEL Classification: G20, G21, G28