Capital and Liquidity Requirements: A Review of the Issues and Literature

In this Article I review the literature on the conceptual and analytical arguments for and against capital adequacy and liquidity requirements for banks, in light of historical and recent experiences and evidence. Much research argues for higher capital adequacy requirements given their beneficial effects in terms of better incentives, greater buffers, and improved interventions in weak banks. The analytical case for liquidity requirements is less well established, and current academic thinking is little reflected in regulations being adopted or underway. While the financial services industries object to these requirements, most analyses show the direct costs to be relatively low. Overall, there is general agreement that the social benefits of higher capital (and perhaps liquidity) requirements likely exceed the private costs given the many externalities and market failures in banking. It is clear though that stricter and better-designed requirements need to be supported by a range of regulations and other actions to have a chance to make the global financial system safer and more efficient.