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Bank Capital and Financial Stability: An Economic Trade-Off or a Faustian Bargain?

Bank Capital and Financial Stability: An Economic Trade-Off or a Faustian Bargain? Financial crises impose large and persistent social costs, making banking stability important. This article reviews the central issues surrounding the role bank capital plays in financial stability. Because the socially efficient capital level may exceed banks’ privately optimal capital levels, regulatory capital requirements become germane. But such requirements may entail various bank-level and social costs. Thus, despite agreement that higher capital would enhance banking stability, recognition of these costs has generated theoretical disagreement over whether capital requirements should be higher. Empirical evidence reveals that, in the cross section of banks, higher capital is associated with higher lending, higher liquidity creation, higher bank values, and higher probabilities of surviving crises. Moreover, increases in capital requirements are met with modest declines in lending. The overarching message from research is that lower capital in banking leads to higher systemic risk and a higher probability of a government-funded bailout that may elevate government debt and trigger a sovereign debt crisis. Thus, capital regulation reform, as well as tax policy, should seek to increase bank capital. This article discusses the contemporary thinking on these issues and concludes with open research questions. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Annual Review of Financial Economics Annual Reviews

Bank Capital and Financial Stability: An Economic Trade-Off or a Faustian Bargain?

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Publisher
Annual Reviews
Copyright
Copyright © 2014 by Annual Reviews. All rights reserved
ISSN
1941-1367
eISSN
1941-1375
DOI
10.1146/annurev-financial-110613-034531
Publisher site
See Article on Publisher Site

Abstract

Financial crises impose large and persistent social costs, making banking stability important. This article reviews the central issues surrounding the role bank capital plays in financial stability. Because the socially efficient capital level may exceed banks’ privately optimal capital levels, regulatory capital requirements become germane. But such requirements may entail various bank-level and social costs. Thus, despite agreement that higher capital would enhance banking stability, recognition of these costs has generated theoretical disagreement over whether capital requirements should be higher. Empirical evidence reveals that, in the cross section of banks, higher capital is associated with higher lending, higher liquidity creation, higher bank values, and higher probabilities of surviving crises. Moreover, increases in capital requirements are met with modest declines in lending. The overarching message from research is that lower capital in banking leads to higher systemic risk and a higher probability of a government-funded bailout that may elevate government debt and trigger a sovereign debt crisis. Thus, capital regulation reform, as well as tax policy, should seek to increase bank capital. This article discusses the contemporary thinking on these issues and concludes with open research questions.

Journal

Annual Review of Financial EconomicsAnnual Reviews

Published: Dec 1, 2014

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