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Optimal capital requirements with noisy signals on banking risk

Author

Listed:
  • Kai Ding

    (California State University, East Bay)

  • Enoch Hill

    (Wheaton College)

  • David Perez-Reyna

    (Universidad de los Andes)

Abstract

We analyze the optimal capital requirement in a model of banks with heterogeneous investment risks and asymmetric information. Asymmetric information prevents depositors from charging an actuarially fair interest rate and leads to cross-subsidization across banks. A leverage constraint reduces the investment of riskier banks, mitigating the pecuniary externality on deposit rates. When policymakers lack information about banking risk, the optimal leverage constraint is tighter than the first-best leverage ratio. When policymakers observe a noisy signal of banking risk, the optimal signal-based leverage constraint is tighter when the signal has worse precision, rather than a larger level of expected risk.

Suggested Citation

  • Kai Ding & Enoch Hill & David Perez-Reyna, 2021. "Optimal capital requirements with noisy signals on banking risk," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 71(4), pages 1649-1687, June.
    • Handle: RePEc:spr:joecth:v:71:y:2021:i:4:d:10.1007_s00199-020-01310-z
    DOI: 10.1007/s00199-020-01310-z
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    More about this item

    Keywords

    Capital requirements; Banking regulation; Asymmetric information;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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