Liberalization, Moral Hazard in Banking and Prudential Regulation: Are Capital Requirements Enough?

Abstract

Capital requirements are traditionally viewed as an effective form of prudential regulation - by increasing capital the bank internalizes more of the risk of its investment decisions. While the traditional view is accurate in the sense that capital requirement can be effective in combating moral hazard, we find, in contrast, that capital requirements are Pareto inefficient. With deposit insurance, freely determined deposit rates undermine prudent bank behavior. To induce a bank to choose to make prudent investments, the bank must have sufficient franchise value at risk. Free deposit rates combined with competitive markets serve to reduce franchise value to the point where banks gamble. Deposit rate controls create franchise value by increasing the per-period profits of the bank. We find that deposit rate controls combined with capital requirements can more inexpensively replicate any outcome that is induced using capital requirements alone. Even in an economy where the government can credibly commit not to offer deposit insurance, the moral hazard problem may still not disappear and capital requirements alone may not achieve the socially efficient allocation, whereas that allocation can be achieved by also using a deposit rate control.