CER-ETH - Center of Economic Research at ETH Zurich, Working Paper No. 09/107
22 Pages Posted: 1 Apr 2009
Date Written: March 1, 2009
In this paper, we argue for a regulatory framework under which a bank's required level of equity capital depends on the equity capital of its peers. Such banking-on-the-average rules are transparent and could also be combined with the current regulatory framework. In addition, we argue that banking-on-the-average rules ensure the build-up of bank equity capitals in booms and thus avoid excessive leverage. Prudent banks can impose prudency on other banks. In a simple model of a banking system, we show that a banking-on-the-average framework can deliver the socially optimal solution because it induces banks to abstain from gambling. Moreover, it alleviates socially harmful consequences of conventional equity-capital rules, which may induce banks to excessively cut back on lending or liquidate desirable long-term investment projects in downturns.
Keywords: banking on the average, equity-capital requirements, banking system, banking crisis
JEL Classification: G21, G28
Suggested Citation: Suggested Citation