Capital requirements, market power, and risk-taking in banking

Abstract

This paper presents a dynamic model of imperfect competition in banking where the banks can invest in a prudent or a gambling asset. We show that if intermediation margins are small, the banks' franchise values will be small, and in the absence of regulation only a gambling equilibrium will exist. In this case, either flat-rate capital requirements or binding deposit rate ceilings can ensure the existence of a prudent equilibrium, although both have a negative impact on deposit rates. Such impact does not obtain with either risk-based capital requirements or nonbinding deposit rate ceilings, but only the former are always effective in controlling risk-shifting incentives.