The result of Proposition 6 also suggests that, when capital is relatively expensive, capital
regulation is not likely to be binding as market incentives will induce banks to hold greater
amounts of capital than is socially optimal. In other words, a minimum capital requirement
imposed by a regulator, as well as changes in this requirement, would have no effect on
banks’ aggregate holdings of capital.7 In fact, social welfare maximization would call for a
ceiling being placed on the level of capital, or a tax on its use so as to discourage banks from
holding excessive capital.
The contrast between the finding in Proposition 6 and that in Proposition 3 is clear.
When there is a shortage of bank funds and banks are able to appropriate most of the
surplus from lending, capital regulation plays a clear role in increasing bank monitoring and
reducing the probability of failure. However, when there is an excess supply of funds and loan
rates are relatively low, the market may demand bank monitoring by requiring that banks
hold a higher amount of capital. The effectiveness of capital regulation, therefore, clearly
depends on the structure of the market for bank credit. When there is an excess demand
for credit, establishing a capital adequacy requirement can be a useful way of imposing bank
discipline, reducing the burden to the insurance fund and raising social welfare. By contrast,
when there is an excess supply of funds, the incentives provided in the market as banks
compete to attract borrowers may lead banks to hold excessive amounts of capital, so that
capital adequacy requirements become ineffective and unnecessary.
6 Extensions
In this section we look at two important extensions. First, we consider the case where there is
no deposit insurance, so that banks must internalize the cost imposed on depositors of their
inability to repay deposits when their projects fail. Second, we consider a simple extension
to allow for banks to shift risk in their choice of investments.
7 This is consistent with the findings of Ashcraft (2001), who finds little evidence that tougher capital
requirements were responsible for the increase in capital ratios throughout the 1980’s.
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