The Welfare Effects of Bank Liquidity and Capital Requirements

Skander Van den Heuvel ()

No 2022-072, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: The stringency of bank liquidity and capital requirements should depend on their social costs and benefits. This paper investigates their welfare effects and quantifies their welfare costs using sufficient statistics. The special role of banks as liquidity providers is embedded in an otherwise standard general equilibrium growth model. Capital and liquidity requirements mitigate moral hazard from deposit insurance, which, if unchecked, can lead to excessive credit and liquidity risk at banks. However, these regulations are also costly because they reduce the ability of banks to create net liquidity and can distort investment. Equilibrium asset returns reveal the strength of demand for liquidity, yielding two simple sufficient statistics that express the welfare cost of each requirement as a function of observable variables only. Based on U.S. data, the welfare cost of a 10 percent liquidity requirement is equivalent to a permanent loss in consumption of about 0.02%, a modest impact. Even using a conservative estimate, the cost of a similarly-sized increase in the capital requirement is roughly ten times as large. Even so, optimal policy relies on both requirements, as the financial stability benefits of capital requirements are found to be broader.

Keywords: Capital requirements; Convenience yields; Banking; Welfare; Liquidity requirements; Sufficient statistics (search for similar items in EconPapers)
JEL-codes: E44 G21 G28 (search for similar items in EconPapers)
Pages: 65 p.
Date: 2022-11-04
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-fdg and nep-rmg
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https://www.federalreserve.gov/econres/feds/files/2022072pap.pdf (application/pdf)

Related works:
Working Paper: The Welfare Effects of Bank Liquidity and Capital Requirements (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2022-72

DOI: 10.17016/FEDS.2022.072

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