The Role of Capital Adequacy Requirements in Sound Banking Systems

Abstract:     
We analyse a general equilibrium model in which there is both adverse selection of and moral hazard by banks. The regulator has two tools at her disposal - she can audit banks to learn their type prior to giving them a licence, and she can impose capital adequacy requirements. When the regulator has a strong reputation for screening she uses capital requirements to combat moral hazard problems. For less competent regulators, capital requirements substitute for screening ability. In this case the banking system exhibits multiple equilibria so that crises of confidence in the banking system can occur. We also show that in either case, a system of deposit insurance funded through general taxation will be welfare-improving and will allow capital requirements to be eased.

Number of Pages in PDF File: 41

Keywords: Capital adequacy, bank regulation, deposit insurance, moral hazard, screening, signalling, adverse selection.

JEL Classification: G21, G28

working papers series