A financial sector crisis was at the heart of the 2007-09 Great Recession in the United States and most other industrial economies.

Since the crisis, policymakers have pursued regulatory reforms designed to strengthen the banking sector, in order to reduce the chances of repeating that economic disaster.

These reforms have focused on increasing the required level of equity capital of banks.

Apart from higher equity and other TLAC, the reforms have also in­cluded the introduction of yearly stress tests, in which bank supervisory agencies review whether banks could withstand adverse shocks to the economy. In the United States, reform has also included curtailment of pro­prietary trading (the “Volcker rule”), as well as the requirement that large banks develop “living wills” that permit orderly “resolution” (the managed winding-down of an effectively bankrupt bank) to avoid catastrophic col­lapses such as that of Lehman Brothers in 2008.

Equity capital is important because it is the cushion of assets in excess of liabilities that can be drawn down before a bank hits the point of in­solvency. Equity is obtained either by issuing new shares or retaining earn­ings (rather than paying them out in dividends). Since the Great Recession, banks have increased equity capital mainly through retained earnings rather than new issuance, which would dilute existing shareholders and, at least initially, would have been on relatively unfavorable terms given market conditions (see Cohen 2013).

In 1988 the Group of Ten advanced industrial countries adopted the first Basel Accord on minimum bank capital requirements, motivated in part by the need to create a level playing field among internationally active banks.

The Great Recession precipitated tougher rules. In late 2010 the Basel Committee on Banking Supervision issued the Basel III rules (BCBS 2010b). They effectively set a minimum of 7 percent of risk-weighted assets for most banks but use a much stricter definition of capital (tangible common equity) than Basel I and Basel II had. For G-SIBs the minimum was set at 9.5 percent.

In late 2015 the Basel III rules were extended to require TLAC amounting to 18 percent of risk-weighted assets for G-SIBs (FSB 2015c). New rules con­straining the use of banks' internal models for estimating risk weights had been scheduled to be completed by the end of 2016. However, disagreement between European and US negotiators and uncertainties associated with the new administration in the United States left this important modifica­tion of the Basel rules still unfinished by April 2017.^[2]

The purpose of this study is to quantify the costs and benefits to the economy from requiring additional bank capital in order to determine whether Basel III struck the right balance between increased financial system safety and potential costs to economic activity. In an early response, the Institute of International Finance (a leading global association of private financial firms) projected that the increase in borrowing costs imposed on economies by the new requirements would cause output in the main indus­trial countries to decline by about 3 percent from levels it would otherwise have reached by 2015 (IIF 2011, 55). At the opposite extreme, a study by two prominent academic experts argues that the new requirements are far too le­nient. Admati and Hellwig (2013, 179) argue that banks should be required to hold 20 to 30 percent of their total assets as equity, which would amount to about 35 to 55 percent of risk-weighted assets for US and euro area banks.

There was thus nearly an order of magnitude difference between the implied optimal levels for equity capital in this technical dispute, an un­usually wide divergence for a central variable of economic policy.^[3] This gap cried out for further analysis.