Why worry about the optimal level of bank capital ratio if 20 percent is good enough?

The most relevant economic studies do not necessarily coincide with those published in top economic journals. It is easy to miss a great study. This paper by the Sverigse Riksbank is a point in case. It was released in december 2011 and I only saw it yesterday. It tries to answer a crucial question I’ve discussed on this blog here and here (in Dutch) – how much bank capital is optimal from a welfare point of view. The answer:  somewhere between 10 and 17 percent. This is in line with previous studies that try to tackle this nasty question, as shown in the table below.

But what is really interesting is the following graph. It shows the effect on gdp of an increase in capital ratios for the various studies, starting from an initial level of 6 percent.  Clearly, when capital ratios are too low the benefits of increasing them is very large: the curve increases steeply for low capital ratios. Remarkably,  however, it flattens out when capital ratios reach the optimal level. This implies that the costs of setting the capital ratio too high (i.e. at 20 percent if 15 percent is optimal)  are much smaller than the costs of setting the capital ratios too low (i.e. at 10 percent instead of 15 percent).

Let me put this differently. In all studies considered here, bluntly setting the capital ratio at 20 percent results in only a very minor loss relative too choosing the optimal level, wheras it results in a significant benefit when compared to the initial level of 6 percent. So why worry about the optimal level of bank capital if you can just set it at 20 percent?

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