Why Are There So Many Banking Crises? The Politics and Policy of Bank Regulation

By Jean-Charles Rochet | Go to book overview

Chapter Eight

Capital Requirements and the Behavior of
Commercial Banks
Jean-Charles Rochet
8.1 Introduction
This paper is motivated by the adoption at the European Community level of a new capital requirement for commercial banks. This reform (fully effective from January 1993) is in fact closely inspired by a similar regulation (the so-called Cooke ratio) adopted earlier (December 1987) by the Bank of International Settlements.I try to examine here what economic theory can tell us about such regulations, and more specifically:
Why do they exist in the first place?
Are they indeed a good way to limit the risk of failure of commercial banks?
What effects can be expected on the behavior of these banks?

In fact, the above questions have already been examined, notably by U.S. economists who have used essentially two competing sets of assumptions. In the first setup, financial markets are supposed to be complete and depositors are perfectly informed about the failure risks of banks. Then the Modigliani-Miller indeterminacy principle applies and the market values of banks are independent of the structure of their assets portfolio, as well as their capital to assets ratio. However, when a bankruptcy cost is introduced, as in Kareken and Wallace (1978), it is found that unregulated banks would spontaneously choose their assets portfolio in such a way that failure does not occur. The reason is market discipline: since capital markets are supposed to be efficient and banks' creditors (including depositors) are supposed to be perfectly informed, any increase in the banks' riskiness would immediately be reflected in the rates of return demanded by stockholders and depositors. It is only when a deposit insurance scheme is introduced that this market

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