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

  • Kevin C. Murdock
  • Thomas F. Hellmann
  • Joseph E. Stiglitz

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.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.90.1.147
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 90 (2000)
Issue (Month): 1 (March)
Pages: 147-165

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Handle: RePEc:aea:aecrev:v:90:y:2000:i:1:p:147-165
Note: DOI: 10.1257/aer.90.1.147
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