Risk Sharing, Creditor Diversity, and Bank Regulation

Abstract

We examine the effectiveness of bank regulation in the light of creditor diversity. Our theory suggests a bank can increase its value by matching the riskiness of its securities and the risk tolerance of its diverse creditors. Even a well-capitalized bank might not eliminate financial fragility in the absence of creditor diversity, because it cannot utilize this matching mechanism. Our simulation finds supporting evidence that capital regulation can improve a bank’s solvency and eliminate financial fragility only when it has diverse creditors. If financial fragility is persistent, we suggest liquidity requirements can mitigate excessive risk-taking.

Keywords: Risk Sharing, Creditor Diversity, Bank Regulation, Self-Fulfilling Prophecy, Capital Regulation, Financial Fragility

JEL Classification: G01, G21, G28