Optimal Capital Requirement with Noisy Signals on Banking Risk

In this paper we analyze the optimal capital requirement in a model of banks with heterogeneous investment risks and asymmetric information. Asymmetric information prevents depositors from charging an actuarially-fair interest rate based on banking risk, and leads to cross-subsidization across banks...

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Bibliographic Details
Published inIDEAS Working Paper Series from RePEc
Main Authors Ding, Kai, Hill, Enoch, Perez-Reyna, David
Format Paper
LanguageEnglish
Published St. Louis Federal Reserve Bank of St. Louis 01.01.2018
Subjects
Banking
Economic models
Interest rate risk
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Summary:In this paper we analyze the optimal capital requirement in a model of banks with heterogeneous investment risks and asymmetric information. Asymmetric information prevents depositors from charging an actuarially-fair interest rate based on banking risk, and leads to cross-subsidization across banks. A capital requirement in the form of a leverage constraint reduces the investment of riskier banks and partially mitigates the pecuniary externality on deposit rates. When depositors and the policymaker have no information about banking risk, only a uniform leverage constraint is possible. In this case, the optimal leverage constraint is tighter than the first-best leverage ratio and strictly improves social welfare. When depositors and the policymaker observe a noisy signal of banking risk, a signal-based leverage constraint is possible. We demonstrate that the optimal signal-based leverage constraint is tighter when the signal has worse precision, rather than a larger level of expected risk.