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Authors estimate FAVAR models individually for eleven euro area economies and identify structural shocks, which allow us to diagnose key vulnerabilities of national banking systems and estimate short-run economic costs of increasing banks’ capitalisation.
On this basis, they run a fully-fledged cost-benefit assessment of an increase in capital buffers. The benefits are related to an increase in bank resilience to adverse shocks.
Higher capitalisation allows banks to withstand negative shocks and moderates the reduction of credit to the real economy that ensues in adverse circumstances.
The costs relate to transitory credit and output losses that are assessed both on an aggregate and bank level.
An increase in capital ratios is shown to have a sharply different impact on credit and economic activity depending on the way banks adjust, i.e. via changes in assets or equity.