The Pre-Commitment Approach in a Model of Regulatory Banking Capital

T he pre-commitment approach to bank capital regulation is a radical departure from existing bank regulatory methods. First proposed in Kupiec and O’Brien (1995c), the approach advocates letting banks choose their capital levels and fining them if losses exceed this level. The essence of the proposal is to use fines (or other penalties) to encourage risky banks to hold more capital than safer ones. Since a change in regulatory method will affect the banking sector, it is crucial to ascertain what will happen if the proposal is implemented. Because the approach is so new, there exists only a small literature explaining and evaluating it. Accordingly, the goal of this paper is to produce understanding of the pre-commitment approach and to determine its effectiveness as a regulatory tool. Regulators care about banks’ capital levels because the deposit insurance fund is liable in the event a bank is unable to repay its depositors. For a given portfolio, a higher ratio of capital to assets reduces the insurance fund’s exposure to losses because there are proportionally fewer deposits to repay in the event of a loss. Along with the monitoring of banks and deposit insurance premiums, capital requirements are an essential part of the mechanism used by regulators to insure deposits. Since 1988, regulators have used capital requirements to protect against credit risk, that is, against the event of borrower default. They have done so by