Social Costs of Bank Capital Requirements in Relation to Lending Incentives
29 Pages Posted: 25 Sep 2012 Last revised: 20 Feb 2013
Date Written: September 25, 2012
Bank capital requirements would entail large social costs if they made resource allocation suboptimal and banking services costly by unduly limiting the banks’ ability to lend. This paper considers three main factors that may make capital requirements relevant, namely, deposit insurance subsidies, stock valuation errors, and tax shields derived from debt financing. The theoretical model analyzes the combined effects of the three factors on the banks’ incentives to make fairly priced loans, which should also be socially optimal loans. A key finding is that the long-term cost of capital requirements is likely to be very small when deposit insurance is underpriced. Short-term adjustment costs can still be large, but it should be relatively easy to mitigate the short-term effects.
Keywords: Capital Requirements, Social Costs, Welfare Costs, Option Value
JEL Classification: G21, G28, E51
Suggested Citation: Suggested Citation