Bank Capital Standards for Market Risk: A Welfare Analysis

We propose a simple model that is suitable for evaluating alternativebank capital regulatory proposals for market risk. Our modelformalizes the conflict between bank objectives and regulatorygoals. Banks' decisions represent a tension between their desireto exploit the deposit-insurance put option and their desireto preserve franchise value. Regulators seek to balance thesocial value of deposits in mediating transactions against thedeadweight costs of failure resolution. Our social welfare criterionis standard: a weighted average agents' utilities. We demonstrate that banks do not incrementally alter their portfoliorisk as the economic environment changes. Rather, banks eitherchoose the minimal feasible risk or the maximal feasible risk.This pattern, in turn, drives regulatory decisions: The firstgoal of the regulator is to induce banks to choose the minimalrisk level. For all nontrivial cases, unregulated banks failto choose the first-best allocations. Traditional ex-ante capitalrequirements can induce banks to choose the socially-optimallevel of portfolio risk, but the required capital is often inefficientlyhigh. In contrast, variants of the Federal Reserve Board's precommitmentproposal imply far smaller efficiency losses, and achieve allocationsat or nearthe first-best for most reasonable model specifications.The ex-post penalties required for the optimal implementationof precommitment are not excessively large. The welfare gainsfrom precommitment are even higher when the precommitment penaltyfunction is precluded from sending banks into default. We concludethat state-contingent regulatory mechanisms, of which the precommitmentapproach is an example, offer the possibility of substantialgains in regulatory efficiency, relative to traditional statenon-contingent regulation.