Crises and Capital Requirements in Banking

We analyse a general equilibrium model in which there is both adverse selection of and moral hazard by banks. The regulator has several tools at her disposal to combat these problems. She can audit banks to learn their type prior to giving them a licence, she can audit them ex post to learn the success probability of their projects, and she can impose capital adequacy requirements. When the regulator has a strong reputation for ex ante auditing she uses capital requirements to combat moral hazard problems. For less competent regulators, capital requirements substitute for ex ante auditing ability. In this case the banking system exhibits multiple equilibria so that crises of confidence in the banking system can occur. Contrary to conventional wisdom, the appropriate response to a crisis of confidence may be to tighten capital requirements to improve the quality of surviving banks.