Deposit competition and effectiveness of bank capital requirements

Abstract

This paper asks how capital requirements differ in their effectiveness in the context of deposit competition and potential misreporting. We present a model in which banks face imperfect competition in the deposit market and choose between a prudent or a risky asset under each of the three capital policies: a leverage ratio, a risk-based capital ratio, and a combination of both. We consider a setting where banks might misreport risky asset choice for lower regulatory capital. We find that, without misreporting, deposit competition needs to be very high to incentivize risky asset choice under the combined policy compared to the others. When misreporting is possible, the risk-based capital ratio alone can incentivize prudent asset choice if competition is below a threshold, but exceeding the threshold renders the ratio ineffective, leading to risky asset choice and misreporting. Adding a leverage ratio can restore incentives for prudent asset choice. However, when competition is too intense, the combined policy may still be ineffective.