We characterize welfare maximizing capital requirement policies in a quantitative macrobanking model with household, firm, and bank defaults calibrated to Euro Area data. We optimize on the level of the capital requirements applied to each loan class and their sensitivity to changes in default risk. We find that getting the level right (so that bank failure risk remains contained) is of foremost importance, while the optimal sensitivity to default risk is positive but typically smaller than under Basel internal ratings based (IRB) formulas. Starting from low levels, savers and borrowers benefit from higher capital requirements. At higher levels, only savers prefer tighter requirements.

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This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.

This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.

This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.