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Benefits and costs of higher capital requirements for banks

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The author derives new estimates of the likely economic losses both from banking crises and from increasing bank capital requirements. According to the paper, a socially optimal level of bank capital is estimated at about 7 to 8 percent of total assets as for the leverage ratio, corresponding to about 12 and 14 percent of risk-weighted assets, respectively. This means that Basel III benchmarks are much below optimal capital requirements. Banks would need to have significantly more capital to adequately protect against financial crisis and risk of a recession, according to the paper.

PIIE working paper no. 16-6
1 March 2016
Source: Peterson Institute for International Economics

Author:
William R. Cline, Peterson Institute for International Economics

>  Benefits and costs of higher capital requirements for banks

Abstract

This study provides new estimates of the likely economic losses from banking crises. It also provides new estimates of the economic cost of increasing bank capital requirements, based on the author’s earlier estimate (Cline 2015) of the empirical magnitude of the Modigliani-Miller effect in which higher capital reduces unit cost of equity capital. The study applies previous official estimates (BCBS 2010a) of the impact of higher capital on the probability of banking crises to derive a benefi ts curve for additional capital, which is highly nonlinear. The benefit and cost curves are examined to identify the socially optimal level of bank capital. Th is optimum is estimated at about 7 percent of total assets, with a more cautious alternative (75th percentile) at about 8 percent, corresponding to about 12 and 14 percent of riskweighted assets, respectively. These levels are, respectively, about one-fourth to one-half higher than the Basel III capital requirements for the large global systemically important banks (G-SIBs).

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