September 7, 2021

Optimal capital ratios for banks in the euro area

Capital buffers help banks to absorb financial shocks. This reduces the risk of a banking crisis. However, on the other hand capital requirements for banks can also lead to social costs, as rising financing costs can lead to higher interest rates for customers. In this research we make an exploratory analysis of the costs and benefits of capital buffers for groups of European countries.

In this study, we estimate the optimal level of capital for banks in the euro area. As far as we know, we are the first to investigate this for the euro area. The optimal level results from a trade-off between the social costs and benefits of capital requirements. Depending on technical assumptions, we find an optimal capital buffer between 15 and 30 percent. Despite this considerable spread, the estimated optimum is in all cases higher than the current minimum requirements of Basel III. We also find significant heterogeneity in the optimum between euro area Member States. For Member States with a more stable economy and a banking sector that can easily attract funding we find lower optimal capital ratios.

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Optimal capital ratios for banks in the euro area

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This analysis is a first step. For example, we estimate the marginal benefits not per country but per group of countries. We thus make no statements about the current capital position of banks in individual member states. In addition, assuming that banks have only domestic exposures is problematic for individual Member States, especially for small and open economies such as the Netherlands. Among other things, a better insight into the international interconnectedness of banks is necessary in order to arrive at an assessment of the social costs and benefits of optimal capital ratios.