Bank Capital Regulation in a Zero Interest Environment

Abstract

How do near-zero interest rates affect bank capital regulation and risk taking? I study these questions in a tractable dynamic equilibrium model, in which forward-looking banks compete imperfectly for deposit funding, and deposit insurance may induce excessive risk taking. If the zero lower bound on deposit rates (ZLB) binds occasionally, optimal capital requirements vary with the level of interest rates, where low rates motivate weaker requirements despite overall higher risk taking. The reason is that the ZLB makes capital regulation less effective in curbing risk shifting incentives, as tight capital requirements erode franchise value when banks cannot pass on the cost of capital to depositors. The model thus highlights a novel interaction between monetary and macro-prudential policies, and shows that it may be desirable to complement existing regulation with policy tools that subsidize the funding cost of banks at the ZLB.

Keywords: Zero lower bound, search for yield, capital regulation, bank competition, risk shifting, franchise value

JEL Classification: G21, G28, E43