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The Role of Capital Adequacy Requirements in Sound Banking Systems

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  • Lucy White
  • Alan Morrison

Abstract

We analyse a general equilibrium 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. When the regulator has a strong reputation for screening she uses capital requirements to combat moral hazard problems. For less competent regulators, capital requirements substitute for screening ability. In this case the banking system exhibits multiple equilibria so that crises of confidence in the banking system can occur. We also show that in either case, a system of deposit insurance funded through general taxation will be welfare-improving and will allow capital requirements to be eased.

Suggested Citation

  • Lucy White & Alan Morrison, 2001. "The Role of Capital Adequacy Requirements in Sound Banking Systems," OFRC Working Papers Series 2001fe04, Oxford Financial Research Centre.
  • Handle: RePEc:sbs:wpsefe:2001fe04
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    File URL: http://www.finance.ox.ac.uk/file_links/finecon_papers/2001fe04.pdf
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