Franchise Values, Regulatory Monitoring, and Capital Requirements in Optimal Bank Regulation

Abstract

This paper demonstrates that financial deregulation is likely to make standard prudential regulatory instruments less effective in curbing excessive risk-taking incentives among banks. This has interesting implications for optimal bank regulation. When there is an increase in competition, the optimal capital requirement should increase, whereas regulatory auditing should decrease. In contrast, when there is an increase in gambling yields, auditing should always increase, whereas the optimal capital requirement may increase or decrease.