Capital Requirements Risk Choice and Liquidity Provision in a Business Cycle Model
This paper develops a quantitative dynamic general equilibrium model in which households' preferences for safe and liquid assets constitute a violation of Modigliani and Miller. I show that the scarcity of these coveted assets created by increased bank capital requirements can reduce overall bank funding costs and increase bank lending. I quantify this mechanism in a two sector business cycle model featuring a banking sector that provides liquidity and has excessive risk taking incentives. Under reasonable parametrizations, the marginal bene t of higher capital requirements related to this channel signi cantly exceeds the marginal cost, indicating that US capital requirements have been sub optimally low.