28 March 2017

More Bank Capital Makes The Economy More Robust

I have long argued that there is basically nothing that can be done from a policy perspective to prevent the business cycle of booms and busts from occurring. But, policy measures can make the economy more robust so that the consequences of a bust are less severe.

A comprehensive study of bank capital levels and business cycles since 1870 supports this conclusion:
Higher capital ratios are unlikely to prevent a financial crisis. This is empirically true both for the entire history of advanced economies between 1870 and 2013 and for the post-WW2 period, and holds both within and between countries. We reach this startling conclusion using newly collected data on the liability side of banks’ balance sheets in 17 countries. A solvency indicator, the capital ratio has no value as a crisis predictor; but we find that liquidity indicators such as the loan-to-deposit ratio and the share of non-deposit funding do signal financial fragility, although they add little predictive power relative to that of credit growth on the asset side of the balance sheet. 
However, higher capital buffers have social benefits in terms of macro-stability: recoveries from financial crisis recessions are much quicker with higher bank capital.

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