Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?
Thomas F. Hellmann
Kevin C. Murdock
Joseph E. Stiglitz
American Economic Review
no. 1, March 2000
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.
Hellmann, Thomas, F., Kevin C. Murdock, and Joseph E. Stiglitz.
"Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?"
American Economic Review,
Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
Financial Institutions and Services: Government Policy and Regulation