Bank Capital Regulation in General Equilibrium

We study whether the socially optimal level of stability of the banking system can be implemented with regulatory capital requirements in a multi-period general equilibrium model of banking. We show that: (i) bank capital is costly because of the unique liquidity services provided by demand deposits, and so a bank regulator may optimally choose to have a risky banking system; (ii) even if the regulator prefers more capital in the system, the regulator is constrained by the private cost of bank capital, which determines whether bank shareholders will agree to meet capital requirements rather than exit the industry. This constraint is tighter when the regulator faces an existing banking system than when the regulator is designing ex ante capital requirements for a new banking system. However, because bank capital is socially costly, optimal ex ante capital requirements may allow some ex post situations in which banks are risky and unwilling to raise additional capital