Quantifying the Effects on Lending of Increased Capital Requirements

There is a strong consensus that reform of the financial regulatory system must include significant increases in the capital requirements for banks. All else equal, this should make the banks safer by providing a greater cushion to survive the mistakes and accidents from which they inevitably suffer. Higher capital requirements should also discourage transactions of lower economic value by creating a higher hurdle rate, since the extra units of capital need to be paid for by additional expected return. Some of the regrettable transactions that seemed attractive during the bubble might not have been undertaken at a higher hurdle rate.

Unfortunately, higher capital requirements are not free. At the margin, the increased hurdle rates are likely to: make it harder for businesses and individuals to obtain loans, raise the cost of loans, lower the interest rates offered to depositors and other suppliers of funds, and reduce the market value of the common stock of existing banks. One of the keys to determining the exact right size for an increase in minimum capital levels is to quantify these effects.

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