An Empirical Economic Assessment of the Costs and Benefits of Bank Capital in the US

Abstract

We evaluate the economic costs and benefits of bank capital in the United States. The analysis is similar to that found in previous studies though we tailor the analysis to the specific features and experience of the U.S. financial system. We also make adjustments to account for the impact of liquidity and resolution-related regulations on the probability of a financial crisis. The conceptual framework identifies the benefits of bank capital with a lower probability of financial crises, which decrease economic output. The costs of bank capital are identified with increases in banks' cost of funding. These increases are passed along to borrowers in the form of higher borrowing costs, resulting in a lower level of economic output. Optimal capital levels maximize the difference between benefits and costs, or maximizes net benefits. Using a range of empirical estimates, we find that optimal bank capital levels in the United States range from just over 13 percent to over 26 percent.We assess the benefits of bank capital through calculating (1) how the probability of a financial crisis declines as the economy-wide level of bank capital increases and (2) the output cost of a financial crisis. The probability of a financial crisis is estimated using a bottom up approach that uses bank-level data from advanced economies and a top down approach that uses aggregate data from the same economies. The output costs associated with a financial crisis are estimated by considering short-run and long-run output costs. Short run costs are taken primarily from recent research by Romer and Romer (2015) that is adjusted to focus more heavily on the experience of large, advanced economies which are more similar to the United States. The long-run costs are estimated assuming that financial crisis either have permanent or temporary but persistent effects. We find that the net present value of the output cost of a financial crisis ranges from roughly 40 to 100 percent of annual GDP.The costs of bank capital arise from the effect of capital on banks' cost of funding. Bank equity is more expensive than debt, but an increase in capital makes investing in banks less risky. Informed by recent research that focuses on U.S. banks, we assume that a bit less than 50 percent of the increase in capital costs is offset by the reduced risk of bank equity. Overall, our results suggest that if banks pass all of the increase in funding costs onto borrowers then borrowing rates would increase by 0.07 percentage points. We also consider a situation in which only half of the increase is passed onto borrowers.Considering the benefits and costs of bank capital in the U.S. that we measure, the level of capital that maximizes the difference between total benefits and total costs ranges from just over 13 percent to Page 2 of 51 just over 26 percent. The reported range reflects a high degree of uncertainty and latitude in specifying important study parameters that have a significant influence on the resulting optimal capital level, such as the output cost of a fi...

Strengthening and Streamlining Bank Capital Regulation

“…If anything, higher and more progressive G-SIB surcharges might have a beneficial incentive effect, by encouraging the largest banks to exit those lines of business where they do not create enough in synergies to outweigh the added social costs associated with their size and interconnectedness. And though this has not been a focus of this paper, others have argued in more detail that the current levels of these surcharges are too low (Passmore and von Hafften 2017;Firestone, Lorenc, and Ranish 2017).…”

Forward-looking and incentive-compatible operational risk capital framework

“…However, industry practitioners have criticized the SMA for lack of risk sensitivity and excessive calibration. particularly for large and complex banks, should be meaningfully more conservative (Admati and Hellwig 2014, Hoenig 2015, Federal Reserve Bank of Minneapolis 2016, Tarullo 2016, Firestone et al 2017. Other academics and most bankers contend that excessive capital requirements reduce bank profitability, hinder lending, and reduce economic growth (Diamond and Rajan 2000, Van den Heuvel 2008, Elliott 2013, Dimon 2017).…”

Forward-looking and Incentive-compatible Operational Risk Capital Framework

“…particularly for large and complex banks, should be meaningfully more conservative (Admati and Hellwig 2014, Hoenig 2015, Federal Reserve Bank of Minneapolis 2016, Tarullo 2016, Firestone et al 2017. Other academics and most bankers contend that excessive capital requirements reduce bank profitability, hinder lending, and reduce economic growth (Diamond and Rajan 2000, Van den Heuvel 2008, Elliott 2013, Dimon 2017).…”