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Rules versus Discretion in Capital Regulation

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  • Urban Jermann
  • Haotian Xiang

Abstract

We study capital regulation in a dynamic model for bank deposits. Capital regulation addresses banks’ incentive for excessive leverage that dilutes depositors, but preserves some dilution to reduce bank defaults. We show theoretically that capital regulation is subject to a time inconsistency problem. In a model with non-maturing deposits where optimal withdrawals make deposits endogenously long-term, we find commitment to have important effects on the optimal level and cyclicality of capital adequacy. Our results call for a systematic framework that limits capital regulators’ discretion.

Suggested Citation

  • Urban Jermann & Haotian Xiang, 2025. "Rules versus Discretion in Capital Regulation," NBER Working Papers 33578, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:33578
    Note: CF EFG
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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • 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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