Bank Regulation and Market Discipline in the Presence of Risk-Shifting Incentives

Abstract

This paper presents a bank capital structure model in which equity holders can increase asset risk once debt is in place. I study the effects of capital requirements and subsidized deposit insurance on the bank's privately optimal funding and operational risk level. The model predicts that there are synergetic effects of regulation and market discipline. When the regulator sets the capital charge and deposit insurance premium payments sufficiently high for a risky portfolio, the bank commits to the low-risk asset portfolio by setting a lower leverage ratio. This market discipline effect disappears when the regulatory costs become too high.

Keywords: Banking, Financial Regulation, Market Discipline, Optimal Capital Structure, Risk-Shifting

JEL Classification: G21, G28, G32, G33