The Optimal Response of Bank Capital Requirements to Credit and Risk in a Model with Financial Spillovers

This paper studies optimal bank capital requirements in an economy where bank losses have financial spillovers. The spillovers amplify the effects of shocks, making the banking system and the economy less stable. The spillovers increase with banks’ financial distortions, which in turn increase with banks’ credit risk. Higher capital requirements dampen the current supply of banks’ credit, but mitigate banks’ future financial distortions. Capital requirements should be raised in response to both an expansion of banks’ credit supply and an increase in the expected future credit risk of banks. They should be lowered close to one-to-one in response to bank losses.