Crises and Capital Requirements in Banking
Description
Joint work with Alan Morrison, Saïd Business School, Oxford.
We analyse a model in which there is both adverse selection of and moral hazard by banks. The regulator has two tools at her disposal to combat these problems - she can audit banks to learn their type prior to giving them a licence, and she can impose capital adequacy requirements. We show that, contrary to existing practice, the tightness of capital adequacy requirements should be decreasing in the perceived competence of the regulator. We also show that if and only if the regulator has a sufficiently poor reputation, the banking system exhibits multiple equilibria so that crises of confidence in the banking system can occur.
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