Crises and Capital Requirements in Banking

We analyze a general equilibrium model in which there is both adverse selection of, and moral hazard by, banks. The regulator can screen banks prior to giving them a licence, audit them ex post to learn the success probability of their projects, and impose capital adequacy requirements. Capital requirements combat moral hazard when the regulator has a strong screening reputation, and they otherwise substitute for screening ability. Crises of confidence can occur only in the latter case, and contrary to conventional wisdom, the appropriate policy response may be to tighten capital requirements to improve the quality of surviving banks. (JEL D51, D82, E58, G21) Despite more than a decade of enforcement of the Basle Capital Adequacy Accord, the pre- cise mechanism through which capital regula- tion promotes the stability of the banking system is still poorly understood. Moreover, the regulatory response to various different banking crises seems to be quite diverse. In turbulent times, should capital requirements be loosened to help struggling banks (as arguably happened in the savings and loans crisis), or should they be tightened to discourage desperate banks from undertaking further risky activities? In this pa- per, we set up a general equilibrium model in which we attempt to explore these questions. Two main theories predominate as to the role capital requirements play. The first of these, which we informally call the "moral hazard" theory, is most closely associated with eco- nomic theorists as well as public choice econo-