Optimal Capital Requirement with Noisy Signals on Banking Risk

Kai Ding (), Enoch Hill and David Perez-Reyna

No 16429, Documentos CEDE from Universidad de los Andes, Facultad de Economía, CEDE

Abstract: In this paper 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 based on banking risk, and leads to cross-subsidization across banks. A capital requirement in the form of a leverage constraint reduces the investment of riskier banks and partially mitigates the pecuniary externality on deposit rates. When depositors and the policymaker have no information about banking risk, only a uniform leverage constraint is possible. In this case, the optimal leverage constraint is tighter than the first-best leverage ratio and strictly improves social welfare. When depositors and the policymaker observe a noisy signal of banking risk, a signal-based leverage constraint is possible. We demonstrate that the optimal signal-based leverage constraint is tighter when the signal has worse precision, rather than a larger level of expected risk.

Keywords: Capital requirements; Banking regulation; Asymmetric information (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
Pages: 31
Date: 2018-07-16
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https://repositorio.uniandes.edu.co/bitstream/handle/1992/41038/dcede2018-39.pdf

Related works:
Journal Article: Optimal capital requirements with noisy signals on banking risk (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:col:000089:016429

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