Bank stability and economic growth: trade-offs or opportunities?

Abstract

Recent debates on banking regulation indicate that regulatory capital improves banking stability but may also impede economic growth. These outcomes suggest that regulatory capital reform may induce a trade-off between bank stability and economic growth. We enter this conversation by investigating the direct relationship between bank stability and economic growth and, further, examine the effect that regulatory capital and institutional quality have on this relationship. Using generalized method of moments on a global panel data set of over 100 countries, across the period 1995–2015, we find no support for a regulatory capital-induced trade-off between banking stability and economic growth. On the contrary, we observe a positive relationship. Moreover, using an innovative approach based on a trade-off metric, we find strong support for the role of regulatory capital in simultaneously maintaining high levels of economic output and banking stability. Institutional quality, however, does not provide evidence of such an effect directly, but enhances the positive effects of regulatory capital. These results provide strong support for the current implementation of increased regulatory capital.