Dynamic Bank Capital Regulation in Equilibrium

We study optimal bank regulation in an economy with aggregate uncertainty. Bank liabilities are used as “money” and hence earn lower returns than equity. In laissez faire equilibrium, banks maximize market value, trading off the funding advantage of debt against the risk of costly default. The capital structure is not socially optimal because external costs of distress are not internalized by the banks. The constrained efficient allocation is characterized as the solution to a planner’s problem. Efficient regulation is procyclical, but countercyclical relative to laissez faire. We show that simple leverage constraints can get the decentralized economy close to the constrained efficient outcome. ∗Gale is at the Department of Economics, New York University. Gamba is in the Finance Group, Warwick Business School, University of Warwick. Lucchetta is at the Department of Economics, University Ca’ Foscari, Venice.