Banking in a Theory of the Business Cycle: A Model and Critique of the Basle Accord on Risk Based Capital Requirements for Banks

Abstract

This paper presents a theoretical framework for understanding the investment decisions and financing decisions of financial and nonfinancial enterprises over the business cycle. At the core of this theoretical framework is an agency problem between relatively more risk averse depositor/bondholders and relatively less risk averse stockholders. The solution to this agency problem is a corporate governance system that takes the form of an up-front contract that directs managers to make portfolio/investment decisions in the interest of their stockholders, and financing decisions in the interest of their depositor/bondholders. This enables depositor/bondholders to offset any risk shifting portfolio/investment decisions made on behalf of the shareholders, thereby mitigating the moral hazard problem among debtors and creditors. The Basle Accord on risk-based capital requirements for depository institutions is one particular regulatory application of this more general theoretical framework. The paper concludes with a comparison between the Basle Accord and the 100 percent reserve or narrow banking proposal as the means of achieving a risk-free medium of exchange and a financial system that facilitates the optimal transfer of resources from savers to investors consistent with society's aversion towards risk.