The Welfare Cost of Banking Regulation
The Basel Accords promote the adoption of capital adequacy requirements to increase the banking sector's stability. Unfortunately, this type of regulation can hamper economic growth by shifting banks' portfolios from more productive, risky investment projects toward less productive but safer projects. This paper introduces banking regulation in an overlapping-generations model and studies how it affects economic growth, banking sector stability, and welfare. In this model, a banking crisis is initiated by an aggregated shock (in the risky sector) in a banking system with implicit bailout, and banking regulation is modeled as a constraint on the maximal share of banks' portfolios that can be allocated to risky assets. This model allows us to evaluate quantitatively the key trade-oÂ®, inherent in this type of regulation, between ensuring banking stability and fostering economic growth. The model implies an optimal level of regulation that prevents crises but at the same time is detrimental to growth. We find that the overall effect of optimal regulation on social welfare is positive when productivity shocks are sufficiently high (for example, in the subprime banking crisis episode) and economic agents are sufficiently risk-averse. Finally, we find that there is a trade-off between regulating the economy upfront (i.e. before the shock) and facing the challenge of making a huge bailout after the crisis.
|Date of creation:||2009|
|Contact details of provider:|| Postal: Newlands on Main, F0301 3rd Floor Mariendahl House, cnr Campground and Main Rds, Claremont, 7700 Cape Town|
Phone: 021 671-3980
Fax: +27 21 671 3912
Web page: http://www.econrsa.org/
More information through EDIRC
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.:
- Frederic S. Mishkin, 2001.
"Prudential Supervision: Why Is It Important and What Are the Issues?,"
NBER Chapters,in: Prudential Supervision: What Works and What Doesn't, pages 1-30
National Bureau of Economic Research, Inc.
- Frederic S. Mishkin, 2000. "Prudential Supervision: Why Is It Important and What are the Issues?," NBER Working Papers 7926, National Bureau of Economic Research, Inc.
- Ennis, Huberto M. & Keister, Todd, 2003. "Economic growth, liquidity, and bank runs," Journal of Economic Theory, Elsevier, vol. 109(2), pages 220-245, April.
- Huberto M. Ennis & Todd Keister, 2003. "Economic growth, liquidity, and bank runs," Working Paper 03-01, Federal Reserve Bank of Richmond.
- Marc G Quintyn & David S. Hoelscher, 2003. "Managing Systemic Banking Crises," IMF Occasional Papers 224, International Monetary Fund.
- Gary Richardson & William Troost, 2006. "Monetary Intervention Mitigated Banking Panics During the Great Depression: Quasi-Experimental Evidence from the Federal Reserve District Border in Mississippi, 1929 to 1933," NBER Working Papers 12591, National Bureau of Economic Research, Inc.
- Van den Heuvel, Skander J., 2008. "The welfare cost of bank capital requirements," Journal of Monetary Economics, Elsevier, vol. 55(2), pages 298-320, March.
- Skander Van den Heuvel, 2005. "The Welfare Cost of Bank Capital Requirements," 2005 Meeting Papers 880, Society for Economic Dynamics.
- Mathias Dewatripont & Jean Tirole, 1994. "The prudential regulation of banks," ULB Institutional Repository 2013/9539, ULB -- Universite Libre de Bruxelles.
- Barth, James R. & Caprio, Gerard Jr. & Levine, Ross, 2004. "Bank regulation and supervision: what works best?," Journal of Financial Intermediation, Elsevier, vol. 13(2), pages 205-248, April.
- Barth, James R. & Caprio Jr., Gerard & Levine, Ross, 2001. "Bank regulation and supervision : what works best?," Policy Research Working Paper Series 2725, The World Bank.
- James R. Barth & Gerard Caprio, Jr. & Ross Levine, 2002. "Bank Regulation and Supervision: What Works Best?," NBER Working Papers 9323, National Bureau of Economic Research, Inc.
- Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, 07.
- Franklin Allen & Douglas Gale, 2003. "Financial Intermediaries and Markets," Center for Financial Institutions Working Papers 00-44, Wharton School Center for Financial Institutions, University of Pennsylvania.
- Kim, Daesik & Santomero, Anthony M, 1988. " Risk in Banking and Capital Regulation," Journal of Finance, American Finance Association, vol. 43(5), pages 1219-1233, December.
- Rui Castro & Gian Luca Clementi & Glenn MacDonald, 2004. "Investor Protection, Optimal Incentives, and Economic Growth," The Quarterly Journal of Economics, Oxford University Press, vol. 119(3), pages 1131-1175.
- Joseph R. Mason, 2005. "A Real Options Approach to Bankruptcy Costs: Evidence from Failed Commercial Banks During the 1990s," The Journal of Business, University of Chicago Press, vol. 78(4), pages 1523-1554, July.
- Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, December.
- Marina Halac & Sergio L. Schmukler, 2004. "Distributional Effects of Crises: The Financial Channel," ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION, ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION, vol. 0(Fall 2004), pages 1-67, August.
- Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
- Blum, Jurg, 1999. "Do capital adequacy requirements reduce risks in banking?," Journal of Banking & Finance, Elsevier, vol. 23(5), pages 755-771, May.
- Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
- World Bank, 2006. "World Development Indicators 2006," World Bank Publications, The World Bank, number 8151, April.
- Balasko, Yves & Shell, Karl, 1980. "The overlapping-generations model, I: The case of pure exchange without money," Journal of Economic Theory, Elsevier, vol. 23(3), pages 281-306, December.
- Ross M. Starr, 1973. "Optimal Production and Allocation under Uncertainty," The Quarterly Journal of Economics, Oxford University Press, vol. 87(1), pages 81-95.
- Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, vol. 90(1), pages 147-165, March.
- Douglas Gale & Martin Hellwig, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Oxford University Press, vol. 52(4), pages 647-663. Full references (including those not matched with items on IDEAS)