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Article
Author(s)

Ryo Kato, Shun Kobayashi and Yumi Saita

Affiliation(s)

1. Bank of Japan, Tokyo 103-8660, Japan 2. Deloitte Touche Tohmatsu, New York 10019-6754, USA

ABSTRACT

This paper aims to propose a framework for estimating the optimal levels of capital at banks, elaborating factors such as liquidity and macroeconomic conditions. Firstly, as a preamble, the authors attempt to reorganize the variety of policy proposals for enhancing financial sector regulation. In light of the broad perspective of the prudential policy framework, the authors discuss the role of bank capital in enhancing banking-sector resilience. Secondly, the authors lay out an early warning system (EWS) to predict a financial crisis where the role of capital and liquidity are explicitly captured. Then, the authors apply the EWS as a component of a cost-benefit analysis (CBA) to gauge the benefit from raising capital and liquidity requirements, as more stringent regulations are expected to reduce the probability of financial crisis. On the other hand, financial-sector regulations should come along with certain costs. To quantify the cost, the authors employ some existing macroeconomic models to estimate the cost of raising capital and liquidity requirements. Combining the EWS (for benefit calculation) with the macroeconomic models (for cost calculation), the authors provide a full-fledged CBA framework that can determine the optimal levels of capital that strike the right balance between the costs and benefits of the financial-sector regulation. The main results indicate that the optimal level of bank capital would considerably vary depending on the level of liquidity indicators both on the asset and liability sides of banks’ balance sheets as well as macroeconomic conditions, typically represented by housing market inflation. Finally, the CBA framework suggests that banks could stand in a better shape with a counter-cyclical capital buffer to be well-prepared for a prospective distress.

KEYWORDS

Capital ratio, liquidity, financial crisis, probit model, bank regulation.

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References
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