The Welfare Effects of Bank Liquidity and Capital Requirements

The stringency of bank liquidity and capital requirements should depend on their social costs and benefits. This paper investigates the welfare effects of these regulations and provides a quantification of their welfare costs. The special role of banks as liquidity providers is embedded in an otherwise standard general equilibrium growth model. In the model, capital and liquidity regulation mitigate moral hazard on the part of banks due to deposit insurance, which, if unchecked, can lead to excessive risk taking by banks through credit or liquidity risk. However, these regulations are also costly because they reduce the ability of banks to create net liquidity and they can distort capital accumulation. For the liquidity requirement, the reason is that safe, liquid assets are necessarily in limited supply and may have competing uses. A key insight is that equilibrium asset returns reveal the strength of preferences for liquidity, and this yields two simple formulas that express the welfare cost of each requirement as a function of observable variables only. Using U.S. data, the welfare cost of a 10 percent liquidity requirement is found to be equivalent to a permanent loss in consumption of about 0.03%. Even using a conservative estimate, the cost of a similarly-sized increase in the capital requirement is about five times as large. At the same time, the financial stability benefits of capital requirements are also found to be broader.