A Further Exploration of Bank Capital Requirements: Effects of Competition from Other Financial Sectors and Effects of Size of Bank or Borrower and of Loan Type

There is a strong consensus among policymakers that there need to be higher minimum capital requirements for banks in order to foster a more stable financial system and to help avoid the recurrence of a financial crisis of the magnitude of the recent one. However, higher capital requirements are not free – banks are likely to lend less, charge more for loans, and pay less on deposits as part of their actions to restore an acceptable return on the larger capital base they will need to employ. Determining the right minimum capital requirements therefore necessitates a careful balancing of the stability benefits against the economic costs of less attractive lending conditions.
Quantifying the likely effects on bank lending of different potential hikes in capital is a key step towards determining that balance. My previous paper, “Quantifying the effects of higher capital requirements on bank lending”, used a straightforward model of loan pricing behavior by banks in order to estimate the effects, which it found to be relatively small. This paper expands on those findings by examining a set of questions that were not fully addressed in the original paper due to time constraints.

Douglas J. Eliott

Brookings Institution

January 28, 2010

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