Liquidity Provision, Bank Capital, and the Macroeconomy

Abstract

New bank equity must come from somewhere. In general equilibrium, raising bank capital requirements means either that banks produce less short-term debt (as debt holders must become shareholders), or short-term debt is not reduced and the banking system acquires nonbank equity (as the shareholders in nonbanks become shareholders in banks). The welfare effects involve a trade-off because bank debt is special as it used for transactions purposes, but more bank capital can reduce the chance of bank failure (producing welfare losses).