Question

What is the optimal amount of bank capital? Review the debate between ADMATI and ELLIOTT. What arguments do you find most convincing?

Answer 1

ADMATI

According to Admati (2010), the increased rates for loans by reducing unnecessary bank lending minimizes the severe bad effects of too-big-to-fail and thus do not impose a social cost. In turn, the real economy is improved. So, the resiliency of the banks is improved by having higher levels of loss absorbing capital leading to a stable financial system. To some researchers this may impact the lending rates and can curtail the invest- ments. If the banks are left alone to their own incentives, they will hold less capital and less liquidity (long-term assets are being funded through short-term debt). The lower levels of capital will not protect the banks in case of loan defaulting and these losses will be accrued in the investments. Thus, increased buffers play a vital role in aligning the incentive of the banks to more socially optimal incentives which in turn will mitigate the systemic crises.

ELLIOT

There is a strong consensus that reform of the financial regulatory system must include significant increases in the capital requirements for banks. All else equal, this should make the banks safer by providing a greater cushion to survive the mistakes and accidents from which they inevitably suffer. Higher capital requirements should also discourage transactions of lower economic value by creating a higher hurdle rate, since the extra units of capital need to be paid for by additional expected return. Some of the regrettable transactions that seemed attractive during the bubble might not have been undertaken at a higher hurdle rate. Unfortunately, higher capital requirements are not free. At the margin, the increased hurdle rates are likely to: make it harder for businesses and individuals to obtain loans, raise the cost of loans, lower the interest rates offered to depositors and other suppliers of funds, and reduce the market value of the common stock of existing banks.  One of the keys to determining the exact right size for an increase in minimum capital levels is to quantify these effects.