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American Economic Review Vol. 90 No. 1 2000

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

Thomas Hellmann1; Kevin C. Murdock2; Joseph E. Stiglitz3

1 Graduate School of Business, Stanford University, Stanford, CA 94305. · 2 Graduate School of Business, Stanford University, Stanford, CA 94305, and McKinsey & Company, 21 South Clark Street, Chicago, IL 60603. · 3 The World Bank, 1818 H Street, NW, Washington, DC 20433, and Department of Economics, Stanford University, Stanford, CA 94305.

Abstract

In a dynamic model of moral hazard, competition can undermine prudent bank behavior. While capital-requirement regulation can induce prudent behavior, the policy yields Pareto-inefficient outcomes. Capital requirements reduce gambling incentives by putting bank equity at risk. However, they also have a perverse effect of harming banks' franchise values, thus encouraging gambling. Pareto-efficient outcomes can be achieved by adding deposit-rate controls as a regulatory instrument, since they facilitate prudent investment by increasing franchise values. Even if deposit-rate ceilings are not binding on the equilibrium path, they may be useful in deterring gambling off the equilibrium path.

DOI
10.1257/aer.90.1.147
Volume
90
Issue
1
Pages
147-165
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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