Bank Capital Regulation with and Without State-Contingent Penalties

51 Pages Posted: 8 Nov 2000

See all articles by David A. Marshall

David A. Marshall

Federal Reserve Bank of Chicago; University of Chicago - Booth School of Business

Edward S. Prescott

Federal Reserve Banks - Federal Reserve Bank of Cleveland

Date Written: September 1, 2000

Abstract

A moral hazard model with exogenous bank franchise value is used to analyze bank capital regulation. Banks choose their capital structure as well as the riskiness and mean of their portfolio. The portfolio mean is determined by the level of costly screening. Screening and portfolio risk are private information, so there are two dimensions to the moral hazard problem. Deposit insurance gives banks an incentive to hold less capital, and to choose a higher-risk, lower-mean portfolio. To mitigate these incentives, capital requirements with and without ex post fines are studied. We find an endogenous reverse mean-variance trade-off in banks' portfolios. Prudent banks choose high-screening, low-risk portfolios and are virtually self regulating. Imprudent banks choose low-screening, high-risk portfolios. Without state-contingent penalties, optimal capital regulations are often V-shaped in bank franchise value. Adding state-contingent regulation can significantly lower capital requirements. Optimal state-contingent regulations are characterized by fines on extreme right-hand-tail returns.

JEL Classification: D820, G210, G280

Suggested Citation

Marshall, David Aaron and Prescott, Edward (Ned) Simpson, Bank Capital Regulation with and Without State-Contingent Penalties (September 1, 2000). FRB Chicago Working Paper No. 2000-10. Available at SSRN: https://ssrn.com/abstract=244055 or http://dx.doi.org/10.2139/ssrn.244055

David Aaron Marshall

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604-1413
United States
312-322-5111 (Phone)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Edward (Ned) Simpson Prescott (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Cleveland ( email )

P.O. Box 6387
Cleveland, OH 44101
United States

HOME PAGE: http://https://www.clevelandfed.org/people-search?pid=f8ca941e-4b51-41f6-95f8-c87f1d3806e5

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