Deposit Insurance, Bank Incentives, and the Design of Regulatory Policy

A large literature studies bank regulatory policies intendedto control moral hazard problems associated with depositinsurance and optimal regulatory design. Much of theanalysis has focused on uniform bank capital requirements,risk-based capital requirements, risk-based or fairly pricedinsurance premium rates, narrow banking, and, morerecently, incentive-compatible designs.All formal analyses employ highly simplifiedtreatments of an individual bank or banking system. Thisstudy is concerned with the appropriateness of modelingsimplifications used to characterize banks’ investmentopportunity sets and access to equity financing. While thecharacteristics of assumed investment opportunities differamong studies, all are highly simplified relative to theactual opportunities available to banks. In some studies,banks are assumed to invest only in 0 net present value(NPV) market-traded securities while in other studies onlyin risky nontraded loans. In models where banks makerisky nontraded loans, loan opportunity set characteristicsare highly specialized. Frequently, a bank is limited to choosing between a high- and a low-risk asset. In boththese cases and those in which loan opportunity sets areexpanded, a well-defined relationship between risk andNPV is assumed. Further, in many analyses, banks areassumed to have unrestricted access to equity capital at therisk-free rate on a risk-adjusted basis.[...]