Optimal Design of Bank Regulation under Aggregate Risk

We develop a tractable general equilibrium model of banking under aggregate risk. Our novel framework includes the main tools of banking regulation—capital and liquidity requirements, deposit insurance and transfers—and shows how they interact and jointly emerge as an optimal response to the inefficiency of the equilibrium of the unregulated economy. This enables us to contribute to several ongoing debates between proponents and opponents of stricter bank regulation. We show that, for low levels of aggregate risk, the general efficient allocation of the economy can be implemented via deposit insurance and transfers alone with no need for capital or liquidity requirements. When aggregate risk exceeds a threshold, however, all four regulatory instruments are essential for efficiency. Capital and liquidity requirements become stricter as aggregate risk increases. Our results, therefore, support the views of opponents of stricter bank regulation when aggregate risk is moderate, but validate the views of proponents when aggregate risk is high. In contrast with recent proposals to reduce or eliminate depositor subsidies to constrain bank leverage, our analysis also demonstrates that depositor subsidies are necessary for efficiency under aggregate risk as they achieve optimal risk-sharing among agents and mitigate underinvestment