Liberalization, Moral Hazard in Banking and Prudential Regulation: Are Capital Requirements Enough?

Stanford GSB Working Paper No. 1466

Sauder School of Business Working Paper

25 Pages Posted: 26 May 1998

See all articles by Thomas F. Hellmann

Thomas F. Hellmann

University of Oxford - Said Business School; University of Oxford - Said Business School

Kevin C. Murdock

McKinsey & Company and Stanford Graduate School of Business

Date Written: December 1997

Abstract

Capital requirements are traditionally viewed as an effective form of prudential regulation - by increasing capital the bank internalizes more of the risk of its investment decisions. While the traditional view is accurate in the sense that capital requirement can be effective in combating moral hazard, we find, in contrast, that capital requirements are Pareto inefficient. With deposit insurance, freely determined deposit rates undermine prudent bank behavior. To induce a bank to choose to make prudent investments, the bank must have sufficient franchise value at risk. Free deposit rates combined with competitive markets serve to reduce franchise value to the point where banks gamble. Deposit rate controls create franchise value by increasing the per-period profits of the bank. We find that deposit rate controls combined with capital requirements can more inexpensively replicate any outcome that is induced using capital requirements alone. Even in an economy where the government can credibly commit not to offer deposit insurance, the moral hazard problem may still not disappear and capital requirements alone may not achieve the socially efficient allocation, whereas that allocation can be achieved by also using a deposit rate control.

JEL Classification: G2, E4, L5

Suggested Citation

Hellmann, Thomas F. and Murdock, Kevin C., Liberalization, Moral Hazard in Banking and Prudential Regulation: Are Capital Requirements Enough? (December 1997). Stanford GSB Working Paper No. 1466; Sauder School of Business Working Paper. Available at SSRN: https://ssrn.com/abstract=92288 or http://dx.doi.org/10.2139/ssrn.92288

Thomas F. Hellmann (Contact Author)

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 (0)1865 288937 (Phone)

HOME PAGE: http://www.sbs.ox.ac.uk/community/people/thomas-hellmann

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 (0)1865 288937 (Phone)

HOME PAGE: http://www.sbs.ox.ac.uk/community/people/thomas-hellmann

Kevin C. Murdock

McKinsey & Company and Stanford Graduate School of Business ( email )

21 S. Clark Street
Suite 2900
Chicago, IL 60603
United States
312-795-7286 (Phone)
253-369-2648 (Fax)

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