Can capital requirements induce private monitoring that is socially optimal?

Capital requirements are a means towards an end.  In the literature on bank capital regulation, the purpose of capital requirements is usually defined in terms of a socially optimal—or, at least, socially preferred—risk configuration for the banking system.  One perspective offered by this literature attributes the source of this risk to the portfolio structure of the banks and motivates capital requirements as a mechanism for reducing portfolio risk.  Another perspective emphasizes the essential management function performed by banks, which suggests a focus on whether capital requirements can influence managerial behavior.  The latter perspective focuses on a bank’s role as a delegated monitor of its asset portfolio.  Bank risk is then directly related to the scope of monitoring chosen by the bank.  Thus, the alternative views propose that capital requirements influence bank decision-making via either an altered risk-return portfolio tradeoff or an altered incentive to change the level of monitoring. 

While the above approaches can be informative about the effects of capital requirements on private decision-making, neither clearly articulates the ultimate objective of capital regulation within a social policy context.  To analyze this issue, we first present an elementary social planner’s problem in which bank monitoring is indispensable for the maximization of social welfare.  We then construct an elementary private banking model.  In contrast to prior models with predetermined equity, an underlying assumption of the private banking model in this paper is that a bank makes its equity-funding choice and monitoring decision simultaneously.  A comparison between the social planner’s and the private bank’s decisions reveals the extent to which the private monitoring solution deviates from the social optimum.  A divergence provides the underlying justification for the imposition of capital requirements.  Because our analysis identifies the specific factors that create a public-private monitoring discrepancy, it can be used to specify the value of the capital ratio that will realign the private monitoring outcome with the optimal public solution.

Our results can be summarized briefly as follows.  The difference between the socially optimal and private value-maximizing monitoring decisions depends on several parameters, including the prevalence of moral hazard behavior and the cost of mitigating this type of behavior. We also find that regulators may be able to impose a capital ratio that will align the private banking system’s monitoring decision with the social optimum.  However, it is highly unlikely that this ratio will be the same for all countries.  Thus, in general, a one-size-fits-all approach to capital regulation is inappropriate.