Deposit Insurance, Bank Incentives, and the Design of Regulatory Policy

Abstract

This study analyzes alternative bank regulatory polices within a theoretical framework that can encompass many policy design issues. Consequences of generalizing banks' investment and financing opportunities for results in the existing literature are examined. Under costless equity issuance, a narrow banking requirement costlessly resolves moral hazard and insurance pricing problems addressed in the literature. With costly equity, minimum capital requirements can be effective but optimal policy design is complicated by its dependence on equity issuance costs, heterogenous bank investment opportunities, and the information requirements these dependencies create. Incentive compatible policy mechanisms appear limited in their ability to resolve the information problems.