The 2007–08 financial crisis exposed the inadequacy of existing prudential regulatory arrangements, spurring various initiatives for reform. 2 One of the main lessons from the crisis was that the banking system held insufficient capital. A key question for policymakers is how much more capital the system should have. This paper presents a framework for assessing the long-run costs and benefits of increasing capital requirements for the economy. It provides background to the analysis presented in Bank of England (2010).

To determine the benefits, we model the banking sector as a portfolio of credit risks, and present a framework for assessing how the likelihood of a systemic banking crisis depends on the level of capital requirements. On costs, we assume that higher capital requirements increase banks’ funding costs. Customers’ borrowing costs rise; leading to a fall in investment and the economic stock of capital, thereby reducing the long-run level of GDP. Here, our key assumption is that Modigliani-Miller’s theorem (Modigliani and Miller (1958)) does not hold in its pure form. If it did hold, variations in a bank’s capital structure would not affect its funding costs. But real-world frictions may imply that funding costs depend on the composition of liabilities. To make our analysis robust against such frictions, we assume that banks’ funding costs increase when they increase the share of capital among their liabilities. We provide some indicative bounds to our estimates using a range of different assumptions.