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.