Bank Capital and Financial Stability: An Economic Trade-Off or a Faustian Bargain?

Financial crises impose large and persistent social costs, making banking stability important. This article reviews the central issues surrounding the role bank capital plays in financial stability. Because the socially efficient capital level may exceed banks' privately optimal capital levels, regulatory capital requirements become germane. But such requirements may entail various bank-level and social costs. Thus, despite agreement that higher capital would enhance banking stability, recognition of these costs has generated theoretical disagreement over whether capital requirements should be higher. Empirical evidence reveals that, in the cross section of banks, higher capital is associated with higher lending, higher liquidity creation, higher bank values, and higher probabilities of surviving crises. Moreover, increases in capital requirements are met with modest declines in lending. The overarching message from research is that lower capital in banking leads to higher systemic risk and a higher probability of a government-funded bailout that may elevate government debt and trigger a sovereign debt crisis. Thus, capital regulation reform, as well as tax policy, should seek to increase bank capital. This article discusses the contemporary thinking on these issues and concludes with open research questions.