Loan Monitoring, Competition, and Socially Optimal Bank Capital Regulations
J. OF RISK AND INSURANCE, Vol. 63 No. 2, June 1996
Posted: 29 Oct 1996
This article analyzes socially optimal bank capital regulations that support fairly-priced deposit insurance. Under full information, banks voluntarily choose a socially optimal interior capital structure based on the cost-benefit tradeoff involved in monitoring loans. Capital regulations are, therefore, redundant. Under asymmetric information, incentive-compatible capital regulations together with fairly-priced deposit insurance are possible if and only if the regulator can prevent bank-borrower collusive side-payments and also observe the rate charged and the equity contributed by the bank for a loan. The bank would then again voluntarily choose the socially optimal interior capital structure and bank capital requirements would be redundant. Greater equity contributions by banks with higher loan quality are then socially optimal. These results highlight the critical importance of bank supervision in effective regulatory policy design.
JEL Classification: G21, G28, D8
Suggested Citation: Suggested Citation