Question

Explain the advantages and disadvantages of increasing capital requirements for banks?

Answer 1

Advantages: Firstly increasing capital requirements for banks will lead to a more stable financial system. Increased capital requirements for banks will lead to more equity and with more equity banks will be in a better position to absorb severe losses. Increasing capital requirements will lead to higher capital buffer for banks and this will make the banks more robust. Besides, banks will be in a position to attract cheaper capital and this in turn will enable them to maintain their current level of lending, even increase it.

Disadvantages: Cost of credit will most likely increase and this can become detrimental to growth. Secondly transaction costs are involved when it comes to raising additional capital. Financial system in the real world is not frictionless (as assumed by Modigliani-Miller) and so there are transaction costs involved for raising funds. Another disadvantage is that markets are not always fully and completely efficient and so the best risk-return tradeoff is not always available.