Why should we be concerned with the level of bank capital? Why is regulatory intervention needed to ensure an optimal level of bank capital? These questions have occupied economists, regulators, and bank managers over the past decades. In this paper, we provide a general equilibrium or macroeconomic perspective on the issues raised above. We highlight the costs and benefits of bank capital. Benefits arise when equity acts as a buffer against losses in the presence of macroeconomic risks or reduces excessive risk-taking of banks. Costs arise because banks compete with industrial firms for equity. Higher bank capital can reduce the amount of equity supplied to industrial firms, thereby increasing moral hazard problems and credit constraints within the industrial firms which the banks are supposed to be easing.
This lowers aggregate income since credit-constrained industrial firms have higher marginal products than investments in frictionless production. The socially optimal capital structure of an economy, or to put it differently, the optimal debt/equity ratios for financial intermediaries and for industrial firms, balance the costs and benefits of bank capital and will therefore maximize aggregate output. The considerations in the paper indicate that the cost of bank capital corresponds to the marginal returns on equity of credit-constrained firms in an economy.
We also show that without regulatory intervention, banks will not and can not raise a socially efficient level of equity. An equilibrium with socially desirable equity levels cannot exist because banks are unable to refrain from risk-taking and offer sufficiently high equity returns simultaneously. Due to competition of other firms for scarce equity, banks need to offer sufficiently high returns to equity holders. If they attracted a sufficient amount of equity, banks would have no incentive to take excessive risks. However, this creates insufficient returns compared to equity channeled into credit constrained firms. As a result, bank equity is lower than the socially optimal equity levels, which induces banks to gamble and enables them to offer sufficiently high equity returns in order to attract equity in the market.
Regulatory capital requirements can eliminate gambling incentives for banks and can induce the socially preferable capital structure. Although we can provide a general equilibrium rationale for regulatory capital requirements, such regulations cannot achieve a first-best allocation. Since under regulatory capital requirements, banks are forced to hold a certain amount of equity, they need to increase loan interest rates in order to generate returns that can attract equity to the extent required.
Thus, capital requirements generate market power. Higher loan interest rates, however, reduce loan sizes for highly productive but credit constrained firms which in turn lowers aggregate output. Therefore, capital adequacy rates must carefully balance three costs: gambling by banks, credit constraints on firms with low equity and credit constraints from high loan interest rates. In our model, the second-best capital requirement rule in the sense of maximizing aggregate output, prescribes an equity level that minimizes the remaining costs as long as gambling by banks is avoided.
