Bank Capital Regulation at the Zero Lower Bound
48 Pages Posted: 22 Feb 2018 Last revised: 1 Mar 2018
Date Written: February 13, 2018
How do near-zero interest rates affect bank competition, risk taking and regulation? I study these questions in a tractable dynamic general equilibrium model, in which forward-looking banks compete imperfectly for deposit funding, and deposit insurance may induce excessive risk taking. The zero lower bound on deposit rates (ZLB) distorts bank competition and boosts risk shifting incentives, particularly if rates are expected to remain near-zero for long. At the ZLB, capital regulation becomes a less effective tool to curb risk shifting incentives. When banks cannot pass on the cost of capital to depositors, tight capital requirements erode franchise value, countervailing the usual "skin in the game" effect. Optimal capital requirements vary with the interest rate cycle, highlighting a novel interaction between monetary and macro-prudential policies. Complementing existing regulation with policy tools that subsidize the funding cost of banks may improve welfare at the ZLB.
Keywords: Zero lower bound, search for yield, capital regulation, bank competition, risk shifting, franchise value
JEL Classification: G21, G28, E43
Suggested Citation: Suggested Citation