The Welfare Cost of Bank Capital Requirements

Wharton Financial Institutions Center Working Paper No. 07-19

39 Pages Posted: 1 Sep 2007  

Skander Van den Heuvel

Federal Reserve Board

Date Written: August 2007

Abstract

Capital requirements are the cornerstone of modern bank regulation, yet little is known about their welfare cost. This paper measures this cost and finds that it is surprisingly large. I present a simple framework which embeds the role of liquidity creating banks in an otherwise standard general equilibrium growth model. A capital requirement limits the moral hazard on the part of banks that arises due to deposit insurance. However, this capital requirement is also costly because it reduces the ability of banks to create liquidity. The key insight is that equilibrium asset returns reveal the strength of households' preferences for liquidity and this allows for the derivation of a simple formula for the welfare cost of capital requirements that is a function of observable variables only. Using U.S. data, the welfare cost of current capital adequacy regulation is found to be equivalent to a permanent loss in consumption of between 0.1 and 1 percent.

Suggested Citation

Van den Heuvel, Skander, The Welfare Cost of Bank Capital Requirements (August 2007). Wharton Financial Institutions Center Working Paper No. 07-19. Available at SSRN: https://ssrn.com/abstract=1008597 or http://dx.doi.org/10.2139/ssrn.1008597

Skander Van den Heuvel (Contact Author)

Federal Reserve Board ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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