Calibrating the Level of Capital: The Way We See It

This paper aims primarily to propose the framework for estimating the optimal levels of capital at banks with broad perspectives, elaborating factors such as liquidity and macroeconomic conditions. First, we attempt to reorganize the variety of policy proposals for enhancing financial sector regulation. In light of the broad perspective of the prudential policy framework, we discuss the role of bank capital in enhancing banking-sector resilience. Second, with our perspective in mind, we lay out an early warning system (EWS) to predict a financial crisis where the role of capital and liquidity are explicitly captured. In the EWS, the estimation results confirm two-fold evidence: (i) capital and liquidity are imperfect substitutes for each other against the probability of crisis. And, on top of the liquidity on the asset side of the banks' balance sheet, (ii) liability-side liquidity has a statistically significant predictive power for a potential financial crisis a few years ahead. Then, we 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, we 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), we 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.