TAILIEUCHUNG - The long-term economic impact of higher capital levels

An important qualifi cation on this theory is that high execu- tive salary needs to result in a benefi t to the society for it to be justifi ed in terms of consequentialist ethics. Increased returns to the fi rm are not suffi cient. Increased effi ciency for the fi rm is a potential justifi cation, but the effi ciency must increase social utility either directly or indirectly. Th is means that the corporation must not be engaged in a legal but socially harmful activity. Improved effi ciency for a corporation engaged in. | The long-term economic impact of higher capital levels Jochen Schanz David Aikman Paul Collazos Marc Farag David Gregory and Sujit Kapadia1 1. Introduction The 2007-08 financial crisis exposed the inadequacy of existing prudential regulatory arrangements spurring various initiatives for One of the main lessons from the crisis was that the banking system held insufficient capital. A key question for policymakers is how much more capital the system should have. This paper presents a framework for assessing the long-run costs and benefits of increasing capital requirements for the economy. It provides background to the analysis presented in Bank of England 2010 . To determine the benefits we model the banking sector as a portfolio of credit risks and present a framework for assessing how the likelihood of a systemic banking crisis depends on the level of capital requirements. On costs we assume that higher capital requirements increase banks funding costs. Customers borrowing costs rise leading to a fall in investment and the economic stock of capital thereby reducing the long-run level of GDP. Here our key assumption is that Modigliani-Miller s theorem Modigliani and Miller 1958 does not hold in its pure form. If it did hold variations in a bank s capital structure would not affect its funding costs. But real-world frictions may imply that funding costs depend on the composition of liabilities. To make our analysis robust against such frictions we assume that banks funding costs increase when they increase the share of capital among their liabilities. We provide some indicative bounds to our estimates using a range of different assumptions. We provide an illustrative quantification of this framework and find that even when Modigliani-Miller s theorem does not hold there is significant scope for increasing capital requirements. This is primarily because the steady-state costs of higher capital requirements are low while the benefits can be substantial. .

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