Bank regulation when both deposit rate control and capital requirements are socially costly

Abstract

AbstractThe bank regulation reforms in the 1980s and 1990s saw deposit rate ceilings being replaced by minimum capital requirements. However, there seem to be no theoretical studies supporting these reforms; either the two instruments are considered for all practical purposes equivalent, or the conclusion is in favor of deposit regulation. In our model there is a real tradeoff between the two: capital regulation is costly because the opportunity costs of capital are higher than the return from normal banking activities, while deposit rate ceilings may result in an inefficiently large number of banks. We show that, depending on the opportunity costs of banking capital and on the severity of the moral hazard problem they seek to address, each of the two regulatory instruments may welfare‐dominate the other.