Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model

Abstract

This paper develops a dynamic general equilibrium model to quantify the effects of bank capital requirements. Households' preferences for liquid assets imply a liquidity premium on deposits. The banking sector supplies deposits and has excessive risk-taking incentives. I show that the scarcity of deposits created by an increased capital requirement can reduce the cost of capital for banks and increase bank lending. A higher capital requirement also increases banks' monitoring incentives, which improves the efficiency of banks' activities. Under reasonable parametrizations, the marginal benefit of a higher capital requirement related to this channel significantly exceeds the marginal cost, indicating that U.S. capital requirements have been suboptimally low.

Keywords: Capital Requirements, Bank Regulation, Bank Lending, Demand for Safe Assets, Business Cycles

JEL Classification: E44, G21, G28