Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model

Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model

January 14,2019Working Paper No. 3554

Accepted at the Journal of Financial Economics

This paper develops a quantitative dynamic general equilibrium model in which households’ preferences for safe and liquid assets constitute a violation of Modigliani and Miller. I show that the scarcity of these coveted assets created by increased bank capital requirements can reduce overall bank funding costs and increase bank lending. I quantify this mechanism in a two-sector business cycle model featuring a banking sector that provides liquidity and has excessive risk-taking incentives. Under reasonable parametrizations, the marginal benefit of higher capital requirements related to this channel significantly exceeds the marginal cost, indicating that US capital requirements have been sub-optimally low.

Keywords
capital requirements, bank regulation, bank lending, demand for safe assets, business cycles