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

Stiglitz, Joseph E.; Hellmann, Thomas F.; Murdock, Kevin C.

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. (JEL G2, E4, L5)

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American Economic Review

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Academic Units
Economics
Published Here
April 10, 2013
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