Bank Regulation When Both Deposit Rate Control and Capital Requirements are Socially Costly

Abstract

We provide a welfare comparison of the two types of banking regulation commonly used to address moral hazard problems, deposit rate ceilings and minimum capital requirements. It is well understood that interference with the price mechanism may lead to inefficiencies -- in the case of a deposit rate ceiling, the expected consequence is financial repression and possibly migration of depositors to unregulated financial institutions. As was already pointed out by Besanko and Thakor (1992), minimum capital requirements are, however, likely to have similar effects, since banks will pass the costs of this regulation on to depositors in the form of lower interest rates. Possibly for this reason there seem to be no theoretical studies supporting the reforms in the 80's and 90's, which saw deposit rate ceilings being replaced by minimum capital requirements. Either the two instruments are considered for all practical purposes equivalent or the conclusion is in favor of deposit regulation. In our model, while both types of regulation may depress deposit rates, there is a real trade-off between the two: capital regulation is costly because the opportunity costs of capital is higher than the return from normal banking activities while deposit rate ceilings may result in an inefficiently high number of banks. We show that, depending on the opportunity costs of banking capital and on the severity of the moral hazard problem they seek to address, each of the two regulatory instruments may welfare dominate the other.