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

We consider a dynamic model of moral hazard in banking to analyze two forms of prudential regulation: capital requirements and deposit rate ceilings. We find that using capital requirments in an economy with freely determined deposti rates yields Pareto inefficient outcomes. 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. In addition to the well-known bonding effect, we show that capital requirements also have a perverse effect of increasing the bank’s cost structure, harming the franchise value of the bank. Deposit rate ceilings, in contrast, improve the bank’s incentives by increasing bank franchise value. We find that deposit rate controls combined with capital requirements can achieve any Pareto efficient outcome where bank’ s invest prudently. Even in an economy where the government can credibly commit not to offer deposit insurance, the moral hazard problem still may not disappear. There continues to be a role for deposit rate ceilings, as capital requirements alone may not achieve the socially efficient allocation. We also show that even if a binding deposit rate ceiling generates inefficient non-price competition, a regulator still may use a non-binding deposit rate ceiling to relax a binding capital requirement.