We analyse a general equilibrium model in which there is both adverse selection of and moral hazard by banks. The regulator has several tools at their disposal to combat these problems. They can audit banks to learn their type prior to giving them a license, they can audit them ex post to learn the success probability of their projects, and can impose capital adequacy requirements. When the regulator has a strong reputation for ex ante auditing they use capital requirements to combat moral hazard problems. For less competent regulators, capital requirements can substitute for ex ante auditing ability. In this case the banking system exhibits multiple equilibria so that crises of confidence in the banking system can occur only when the regulator’s reputation is poor. Contrary to conventional wisdom, depending on regulator reputation the appropriate policy response to a crisis of confidence may be to tighten capital requirements to improve the quality of surviving banks.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
4364.
Find related papers by JEL classification: D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Douglas W. Diamond & Raghuram G. Rajan, 2000.
"A Theory of Bank Capital,"
Journal of Finance,
American Finance Association, vol. 55(6), pages 2431-2465, December.
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Douglas W. Diamond & Raghuram G. Rajan, .
"A Theory of Bank Capital,"
CRSP working papers
363, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)
Hendrik Hakenes & Isabel Schnabel, 2006.
"Bank Size and Risk-Taking under Basel II,"
Discussion Papers
88, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
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