DP16680 Misdiagnosing Bank Capital Problems

Author(s): Jeremy Bulow, Paul Klemperer
Publication Date: October 2021
Keyword(s): bank capital, bank runs, Capital requirements, financial crisis, Liquidity Runs, Regulatory capital, Regulatory forbearance, Solvency Runs, stress tests
JEL(s): G10, G21, G28, G32
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16680

Banks' reluctance to repair their balance sheets, combined with deposit insurance and regulatory forbearance in recognizing greater risks and losses, can lead to solvency problems that look like liquidity (bank-run) crises. Regulatory forbearance incentivizes banks to both retain risky loans and reject new good opportunities. With sufficient regulatory forbearance, partially-insured banks act exactly as if they are fully insured. Stress tests certify that uninsured creditors will be paid, not that banks are solvent, and have ambiguous effects on the efficiency of investment.