Bank Capital and Equity Investment Regulations

This paper uses an intermediation model to study the efficiency and welfare implications of both banks’ required capital-asset ratio and the regulation that limits, and in some countries forbids, banks’ investments in equity to a certain proportion of each firm’s capital. There are two sources of moral hazard in the model: one between the bank and the provider of deposit insurance, and the other between the bank and the entrepreneur who demands funds to finance an investment project. Among other things, the paper shows that capital regulation irnproves the bank’s stability and can also be Pareto-improving. Equity regulation is never Pareto-improving and does not increase the bank’s stability.