Bank Capital Regulation in a Zero Interest Environment

Abstract

How does the zero lower bound on deposit rates (ZLB) affect how banks react to capital regulation? I study this question in a dynamic model in which households value the liquidity services of deposits, yet do not accept negative deposit rates. When deposit rates are constrained by the ZLB, tight capital requirements disproportionately hurt franchise values and are therefore less effective in curbing excessive risk-taking. The model delivers a novel rationale for “interest-dependent” capital regulation that is optimally laxer when the ZLB binds and tighter when the ZLB is slack but may bind in the future.

Keywords: Zero lower bound, capital regulation, franchise value, interest rates, reach for yield, monetary policy

JEL Classification: G21, G28, E43, E58