Is the Cost of a Safer Banking System Lower Economic Activity?

Abstract

The effect of a stronger bank capital base on economic growth remains unsettled in the literature. We investigate the presence and strength of two transmission channels—financial stability and bank lending channels—to shed more light on the association between bank capital and economic activity. Drawing evidence from 47 advanced and developing countries over close to 2 decades and using a PVAR and a system GMM, we find that higher capital ratios improve financial stability and lending activity, ultimately exerting a positive influence on economic activity. The effect on real GDP growth is economically significant, reaching up to 1¼ percentage points for each percentage point acceleration in capital increases. Our main results are robust to various sensitivity tests, supporting the conclusion that safer banking systems do not bridle economic activity.

Keywords: Bank capital, Financial stability, Bank lending, Economic growth

JEL Classification: E44, E51, G21, G28