Rewarding Prudence: Risk Taking, Pecuniary Externalities and Optimal Bank Regulation

This paper provides a new rationale for macroprudential regulation and studies its optimal design, implementation, and distributional consequences. In a partial equilibrium model where bank risk taking is subject to moral hazard, we show that although private contracting can solve the bank's agency (i.e., risk shifting) problem, the market outcome is constrainedinefficient: The combination of moral hazard and competition for deposits that are not supplied elastically leads to a pecuniary externality as raising deposits ultimately increases the deposit rate and exacerbates risk shifting of all other banks. As a result, banks are too large, have too much leverage, and take excessive risk. This generic inefficiency provides a strong rationale for regulation even in the absence of classical frictions such as social cost of bank failure or incorrectly priced deposit insurance. The pecuniary externality can be internalized by standard regulatory tools such as capital requirements or by issuing a specific number of banking licenses. Related to the idea of financial restraint, optimal regulation creates rent opportunities to reward prudent banks. This also leads to redistribution from depositors to banks and firms with access to the capital market such that optimal regulation is not a Pareto improvement.