Dynamic Prudential Regulation

We analyze the design and impact of bank regulation using a dynamic structural framework. The optimal regulatory policy combines a target capital requirement, the mitigation of underinvestment, an intervention capital requirement to control inefficient risk-taking, and recapitalization of distressed banks. The optimal target and intervention capital requirements are consistent with the substantially higher capital requirements proposed in the Basel III agreement, and together achieve most of the benefits of regulation by alleviating underinvestment and asset substitution. They are interdependent and respond in different ways to banks' asset characteristics, suggesting that regulatory policies should be carefully tuned to the economic environment.