By Caterina Mendicino, Kalin Nikolov, Juan Rubio-Ramirez, Javier Suarez and Dominik Super
Episodes such as the current coronavirus (COVID-19) crisis might lead to a significant rise in borrower defaults and, consequently, weakness in the banking sector. Having well-capitalised banks makes the financial system more resilient to such episodes. We assess how much capital would be optimal for banks to hold, taking into consideration the risk of banking crises driven by borrower defaults (which we term “twin default crises”).
We find that, in the context of our model, bank capital requirements of around 15% provide the optimal trade-off between lowering the frequency of banking crises caused by borrower defaults and maintaining the availability of credit in normal times. While the exact figure depends on a number of assumptions, it is higher than the Basel III minimum and than the optimum implied by macroeconomic frameworks that underestimate or neglect the impact of borrower default on bank solvency.