DP13152 Bank Capital in the Short and in the Long Run

Author(s): Caterina Mendicino, Kalin Nikolov, Javier Suarez, Dominik Supera
Publication Date: September 2018
Keyword(s): Bank Fragility, Default Risk, effective lower bound, Financial Frictions, macroprudential policy, Transition Dynamics
JEL(s): E3, E44, G01, G21
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13152

How far should capital requirements be raised in order to ensure a strong and resilient banking system without imposing undue costs on the real economy? Capital requirement increases make banks safer and are beneficial in the long run but carry transition costs because their imposition reduces aggregate demand on impact. Under accommodative monetary policy, increasing capital requirements addresses financial stability risks without imposing large transition costs on the economy. In contrast, when the policy rate hits the lower bound, monetary policy loses the ability to dampen the effects of the capital requirement increase on the real economy. The long-run benefits of higher capital requirements are larger and the transition costs are smaller when the risk that causes bank failure is high.