Bank capital and economic activity

Banks argue that holding higher capital will have adverse implications on their lending activities and thereby on economic growth. Yet, the effect of a stronger capital base on economic growth remains largely unsettled. We argue that better capitalized banks improve financial stability conditions and, in dire times, they are able to sustain credit to the economy thereby containing adverse macroeconomic implications. Using various methods, we test for the presence and strength of a financial stability channel and a bank lending channel by drawing evidence from 47 advanced and developing countries over close to two decades. We find that higher capital ratios improve financial stability and help sustain bank lending, ultimately exerting a positive influence on economic activity. These effects on real GDP growth are economically significant, reaching up to 1¼ percentage points for each percentage point acceleration in capital. Our main results are robust to various sensitivity checks, supporting the conclusion that safer banking systems do not bridle economic activity.