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American Economic Review: Vol. 90 No. 1 (March 2000)

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

Article Citation

Hellmann, Thomas F., Kevin C. Murdock, and Joseph E. Stiglitz. 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?" American Economic Review, 90(1): 147-165.

DOI: 10.1257/aer.90.1.147

Abstract

In a dynamic model of moral hazard, competition can undermine prudent bank behavior. While capital-requirement regulation can induce prudent behavior, the policy yields Pareto-inefficient outcomes. Capital requirements reduce gambling incentives by putting bank equity at risk. However, they also have a perverse effect of harming banks' franchise values, thus encouraging gambling. Pareto-efficient outcomes can be achieved by adding deposit-rate controls as a regulatory instrument, since they facilitate prudent investment by increasing franchise values. Even if deposit-rate ceilings are not binding on the equilibrium path, they may be useful in deterring gambling off the equilibrium path.

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Authors

Hellmann, Thomas F. (Stanford U)
Murdock, Kevin C. (Stanford U and Mckinsey & Co, Chicago)
Stiglitz, Joseph E. (World Bank)

JEL Classifications

G21: Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
G28: Financial Institutions and Services: Government Policy and Regulation


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