Capital requirements and process innovation

This paper investigates the relationship between the optimal level minimum capital requirements aimed at preventing moral hazard by banks and banks’ incentives to invest in process innovation aimed at improving operational efficiency. We extend Hellmann et al (2000)’s dynamic model of banking competition to show that the imposition of minimum effective capital requirements aimed at preventing excessive risk-taking by banks supports, rather than hinders, investment in process innovation, thanks to the longer time horizon over which banks can expect to benefit from the efficiency improvement thereof. This is because investments in process innovation will be more valuable if banks act prudently. This in turn reduces the incentive for moral hazard with implications for the optimal level of minimum capital requirements.