A theory of bank capital

Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creatin g a role for outside bank capital. Greater bank capital reduces the probabi lity of financial distress but also reduces liquidity creation. The quantit y of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, co sts of bank distress, and the ability to force borrower repayment. The mode l explains the decline :in bank capital over the last two centuries. It ide ntifies overlooked consequences of having regulatory capital requirements a nd deposit insurance.