Basel II attempts to eliminate incentives for regulatory capital arbitrage and align capital regulation with best practices in credit risk management. Despite the imposition of very heavy compliance costs, it is unlikely to succeed in achieving either goal. This paper describes an alternative approach, based on mandatory issues of subordinated debt, which makes use of market discipline to achieve these goals at much lower cost.

We develop a model of lender behavior in the presence of default risk and moral hazard that determines default premiums and identifies the conditions under which borrowers are rationed. A hypothesis regarding a cognitive bias in the formation of expectations provides a dynamic component to our analysis and allows us to explain how an economy becomes vulnerable to a financial crisis and why vulnerability may increase over time.

Bank failures and the official safety net lessons of the great crash banking and securities business - the separate issues the US Glass-Steagall Act reforming Japan's financial system UK financial regulation after big bang the new financial regulatory framework in Canada universal banking - Germany and Switzerland the EEC's new regulatory regime weighing the policy alternatives - theory and practice a risky experiment post-script - the Bank of Credit and Commerce International.

We show that growth opportunities which cannot be converted to cash under conditions of financial distress are a critical determinant of an intermediary's choice of risk. Financial institutions in which is a low proportion of total assets will be much more likely to engage in go‐for‐broke behavior. The model leads to a reevaluation of the effectiveness of several traditional remedies for dealing with banks that take excessive risks such as raising insurance premiums, intervening before capital is depleted, and restricting investment options. The model also has implications about a new approach to the examination of financial intermediaries.

We show that growth opportunities which cannot be converted to cash under conditions of financial distress ( G z ) are a critical determinant of an intermediary's choice of risk. Financial institutions in which G z is a low proportion of total assets will be much more likely to engage in go-for-broke behavior. The model leads to a reevaluation of the effectiveness of several traditional remedies for dealing with banks that take excessive risks such as raising insurance premiums, intervening before capital is depleted, and restricting investment options. The model also has implications about a new approach to the examination of financial intermediaries.