Capital Requirements, Risk Choice, and Liquidity Provision in a Business Cycle Model ,” Working paper

This paper develops a quantitative dynamic general equilibrium model in which households ' preferences for safe and liquid assets constitute a violation of Modigliani and Miller. I show that the scarcity of these coveted assets created by increased bank capital requirements can reduce overall bank funding costs and increase bank lending. I quantify this mechanism in a two-sector business cycle model featuring a banking sector that provides liquidity and has excessive risk-taking incentives. Under reason-able parametrizations, the marginal benefit of higher capital requirements related to this channel significantly exceeds the marginal cost, indicating that US capital require-ments have been sub-optimally low