The effects of stringent capital requirements on large financial institutions

Abstract

With the growing size of the interbank financial market, it is often argued that capital regulations for large wholesale banks should be more stringent than for small retail banks. This study constructs a general equilibrium model incorporating both wholesale and retail banks under capital regulation to discuss whether wholesale banks should face tighter leverage restrictions than retail banks. The simulations assuming various degrees of capital regulation on wholesale and retail banks show that stringent capital requirements for wholesale banks improve financial stability. The inefficiencies brought about by capital regulations are mitigated as a result of agents’ anticipation of stability. In contrast, capital regulations on both wholesale and retail banks destabilize the interbank market, because a large drop in asset prices reduces expectations that wholesale banks will be able to meet their obligations. These results imply that the stabilizing effect of capital regulation dominates inefficient asset allocation and thus provide theoretical support for the recent regulatory reforms imposing tight capital regulations on large influential financial institutions.

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Correspondence to Asako Chiba.

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I would like to express my sincere gratitude to Kosuke Aoki, Tomohiro Hirano, Ryuzo Miyao, Tomoyuki Nakajima, and Kenichi Ueda at the University of Tokyo for helpful advice. This work was supported by a JSPS Grant-in-Aid for JSPS Fellows (JSPS KAKENHI Grant Number 16J04159).

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Chiba, A. The effects of stringent capital requirements on large financial institutions. J Regul Econ 57, 231–257 (2020). https://doi.org/10.1007/s11149-020-09407-y

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Keywords

  • Financial crisis
  • Basel III
  • Capital regulation
  • Systemically important financial institutions (SIFIs)

Mathematics Subject Classifications

  • G01
  • G21
  • G23
  • G28