Optimal Bank Capital

This article reports estimates of the long-run costs and benefits of having banks fund more of their assets with loss-absorbing capital, or equity. We model how shifts in funding affect required rates of return and how costs are influenced by the tax system. We draw a clear distinction between costs to individual institutions (private costs) and overall economic (or social) costs. We find that the amount of equity capital that is likely to be desirable for banks to use is very much larger than banks have used in recent years and also higher than targets agreed under the Basel III framework. This article reports estimates of the long-run costs and benefits of having banks fund more of their assets with loss-absorbing capital – by which we mean equity – rather than debt. The benefits come because a larger buffer of truly loss-absorbing capital reduces the chance of banking crises which, as both past history and recent events show, generate substantial economic costs. The offset to any such benefits comes in the form of potentially higher costs of intermediation of saving through the banking system; the cost of funding bank lending might rise as equity replaces debt and such costs can be expected to be reflected in a higher interest rate charged to those who borrow from banks. That in turn would tend to reduce the