The Long-Term Effects of Capital Requirements
52 Pages Posted: 14 Jun 2021 Last revised: 6 Aug 2021
Date Written: March 8, 2021
We build a stylized dynamic general equilibrium model with financial frictions to analyze costs and benefits of capital requirements in the short-term and long-term. We show that since increasing capital requirements limits the aggregate loan supply, the equilibrium loan rate spread increases, which raises bank profitability and the market-to-book value of bank capital. Hence, banks build up larger capital buffers which (i) lowers the public losses in case of a systemic crisis and (ii) restores the banking sector’s lending capacity after the short-term credit crunch induced by tighter regulation. We confirm our model’s dynamic implications in a panel VAR estimation, which suggests that bank lending has even increased in the long-run after the implementation of Basel III capital regulation.
Keywords: Bank capital requirements, credit crunch, systemic risk
JEL Classification: E21, E32, F44, G21, G28
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