Bank Capital and Financial Stability: An Economic Tradeoff or a Faustian Bargain?

Financial crises impose large and persistent social costs, making banking stability an important regulatory goal. This paper provides a review of the central issues related to the role bank capital plays in financial stability and the prudential regulation issues engendered by this centrality. I begin with a description of the views of three distinct groups on bank capital: bankers, regulators and academics. Because social efficiency and financial stability concerns may call for higher capital levels than those that are privately-optimal for banks, regulatory capital requirements become germane. But it is often argued that such requirements may themselves entail various bank-level and social costs. Recognition of these costs means that, while there is broad agreement that banking stability would be enhanced by higher capital levels in banking, there is substantial disagreement in the theoretical literature over whether capital requirements should be significantly higher. The issue thus needs empirical adjudication. The empirical evidence reveals that, in the cross-section of banks, higher capital ratios are associated with higher lending, higher liquidity creation, higher bank values, and higher probabilities of surviving crises. Moreover, increases in capital requirements are met with modest declines in bank lending. While the issues are complex and the evidence does not conclusively settle the issue, the overarching message from the research and recent experience is that higher leverage in banking leads to higher systemic risk and a higher probability of a large government-funded bailout that may cause government debt to spike up and trigger a sovereign debt crisis with devastating social costs. This means that an important goal of capital regulation reform, as well as tax policy, ought to be to increase capital levels in banking, thereby strengthening a form of ?private deposit insurance?. The paper discusses the contemporary thinking on these issues, and concludes with an indication of the most compelling open research questions.