In a dynamic model of moral hazard, competition can undermine prudent bank behavior. While capital-requirement regulation can induce prudent behavior, the policy yields Pareto-inefficient outcomes. Capital requirements reduce gambling incentives by putting bank equity at risk. However, they also have a perverse effect of harming banks' franchise values, thus encouraging gambling. Pareto-efficient outcomes can be achieved by adding deposit-rate controls as a regulatory instrument, since they facilitate prudent investment by increasing franchise values. Even if deposit-rate ceilings are not binding on the equilibrium path, they may be useful in deterring gambling off the equilibrium path.
Hellmann, Thomas, Kevin Murdock, and Joseph Stiglitz. "Liberalization, Moral Hazard in Banking and Prudential Regulation: Are Capital Requirements Enough?" American Economic Review 90, no. 1 (March 2000): 147-165.
Each author name for a Columbia Business School faculty member is linked to a faculty research page, which lists additional publications by that faculty member.
Each topic is linked to an index of publications on that topic.