Bank Capital Regulation

When having the fixed insurance premia policy (more broadly, a mispriced deposit insurance
premia policy), it was identified the bank’s risk-shifting effect with their decision to finance risky
instead of safe projects (i.e., moral hazard problem).

Fixed Insurance Premia Moral Hazard

Fair Insurance Premia No Moral Hazard

How to reduce banks’ risk-taking incentives (assuming a

fixed insurance premia)?

Leverage and Increasing

Minimum Capital
Volatility of Banks’
Requirements
Assets Incentives

Concentration Risk-
taking Incentives in Concentration Limits
specific assets
and/industries

Risk-taking Incentives
thorough increasing Risk-based Capital
volatility of banks’ Requirements
assets

Regulators can reduce the bank’s risk-taking incentives by requiring banks to meet a risk-based
capital requirement, leading to a reduction in bank’s leverage and bank’s assets risk.

Another aspect should be emphasized, when limited liability is considered and bank capital is
exogenously set at a certain level the convexity of preferences due to limited liability may dominate
risk aversion, and the bank, if undercapitalized, will behave as a risk lover. In this case, even a
risk-based capital regulation that makes use of ‘market-based’ risk weights (that is, weights
proportional to the systematic risks of the assets as measured by their market betas) may not be
enough to restrain the bank’s appetite for risk. It may be necessary to impose an additional
regulation, for example, to require banks to operate with a minimum capital level.

A key aspect of modern banking theory not considered in this literature is the existence of
information asymmetries (no observation of entrepreneur’s effort). These are important
because they are directly related to the existence of banks. Santos (1999) considers the role of
information asymmetry, in the following model:

Model to Minimum Capital Requirements

Rationale
An increase in capital standards leads to higher costs in case of bankruptcy (as the bank it is forced
to operate with lower leverage, resulting in more ‘money at stake’ for banks). Additionally, it leads
to a higher cost of funding (as capital is more expensive than deposits). Given this, the bank will
change the financing contracts with firms to induce firms to lower their risk, which in turns reduces
the bank’s risk of insolvency.

Assumptions
Assumption 1: N risk-neutral projects, each with an identical investment project, but without the
necessary funds to finance it. Projects are perfectly correlated. Each of them requires an initial
investment equal to I , and produces one period later the total return y i with probability pi. We
assumed only three possible returns: y 0 < y 1 < y 2, where y 0 ≡0 and y= { y 1 , y 2 } . The sum of
probabilities must be: p0 + p1 + p2 = 1.

Assumption 2: The probability distribution of the project’s returns is assumed to be an

endogenous variable because it depends on the entrepreneur’s effort. Moreover, it is also
assumed that the entrepreneur incurs a cost for each level of effort he chooses. The entrepreneur’s
cost function: C ( p ) =0.5 a1 p 21+ 0.5 a2 p 22+ a3 p 2 with a i> 0 for i=¿1, 2, 3. In this cost function, we
understand that a possible outcome of y 0 ≡0 with probability p0 does not demands effort for the
entrepreneur and thus a zero cost inherent. Moreover, achieving an outcome of y 2 with probability
p2 requires relatively more effort and cost than achieving an outcome of y 1 with probability p1 from
the entrepreneur’s part.
Assumption 3: The opportunity cost of the bank’s capital r (.) is increasing at an increasing rate.
Furthermore, it is assumed that r (.)>(i+ q), wherei is the risk–free interest rate and q is the deposit
insurance premium that the bank pays at the end of the period, per unit of the deposits it holds.
K
Finally, the bank must satisfy a minimum capital–asset ratio: ≥ θ, where θ is the required capital
I
asset ratio.

Assumption 4: The public in this economy is risk–averse. It is willing to supply any amount of
deposits, provided it is paid the certainty equivalent to the risk–free interest rate.

Bank’s Maximization Problem Formulation

Let r i be the payment required by the bank contingent on the return y i. Because of the limited
liability condition, we have r 0 ≡ 0, since by assumption y 0 ≡ 0, and r i ≤ y i for i= 1, 2.

Under these circumstances, the problem that the firm solves is the following ( e is a vector of ones
and r i are the payments demanded by the bank):

max π E= p1 ( y 1−r 1 ) + p2 ( y 2−r 2) −C ( p )

p

s . t . : pe ≤ 1
p>0

Next, under these circumstances, the problem that the bank must solve is ( B are the deposits,
R ( K ) ≡ [ 1+r (K ) ] K and Q ≡ [ ( 1+i ) +q ], with q as the fixed insurance premia):

max π E= p1 Max ( 0 , r 1−B Q ) + p 2 Max ( 0 , r 2−B Q )−R ( K )

r, n, K

s . t . :π E =p 1 ( y 1−r 1 ) + p 2 ( y2 −r 2 )−C ( p ) (The firm’s profits are not negative)

y 1−r 1 −a1 p 1=0 (Entrepreneur incentive constraint, first-order condition to the firm’s maximization
problem, ‘rule’ by which the entrepreneur follows when deciding its effort to put on the business)

y 2−a3−r 2 −a2 p 2=0 (Entrepreneur incentive constraint, first-order condition to the firm’s
maximization problem, ‘rule’ by which the entrepreneur follows when deciding its effort to put on
the business)

0 ≤ r i ≤ y i for i = 1, 2 (Payments demanded by the bank lower or equal to firm’s outcomes)

K + B=I and K ≥θ I (Bank finances itself through capital and deposits and bank’s capital need to
accomplish at least the minimum capital requirements)
Propositions
Proposition 1: The optimal contract to the problem defined here is ( I , p¿ , r ¿ ) , where:

Proposition 2: An increase in the bank’s minimum capital requirements implies (a) an increase in
¿ ¿
both probabilities of positive outcomes, ( p1, p2) and, as a result, a decrease in the projects’
¿
probability of failure ( p0), which is also the bank’s probability of failure, and (b) an increase in the
profits of each entrepreneur and, within a certain range, an increase in the bank’s profits.

Corollary
 Fixed Insurance premia case: When the capital–asset ratio is increased, forcing the bank to
substitute capital for deposits, it increases the value of what the bank’s equity holders have
at stake in case of bankruptcy. As a result, in order to minimize its costs in case of bank’s
failure, the bank adjusts the contract it uses to finance entrepreneurs in order to motivate
them to choose a safer behaviour.
 Endogenous Insurance premia case: With an endogenous insurance premia, there is no
moral hazard. When introducing regulation with minimum capital levels, in this case, if the
gains of that regulation outweigh the costs imposed on the bank (i.e., higher cost of funding
when substituting deposits for capital and, consequently, higher cost of capital), then an
increase in the capital-asset ratio implies an increase both in the number of projects financed
by the bank and in its profits. Note that because the cost of the bank’s capital increases at an
increasing rate, eventually after a certain level of capital has been reached, further increases
in the required capital–asset ratio will imply a reduction in the number of projects financed
and ultimately a decline in the bank’s profits.