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In a model with endogenous risk-taking, deposit insurance and limited liability may
lead banks to make risky loans that are socially inefficient. Capital requirements can
prevent excessive risk-taking at the cost of reducing liquidity-producing bank deposits.
A policy that sets capital requirements just high enough to prevent excessive risktaking
will move capital requirements pro-, counter-, or a-cyclically depending on the
shock source. However, such a policy requires full knowledge of all the shocks hitting the
economy and is not implementable. Simple rules that respond to cyclical conditions—in
line with Basel III guidance—perform poorly, whereas a small static capital buffer can
do much better.
