Aggregate Risk, Bank Competition and Regulation in General Equilibrium

We investigate the optimal design of bank regulation by developing a tractable general equilibrium model of competitive banks who are exposed to idiosyncratic and aggregate risk. A comparison of the autarkic equilibrium allocations with the efficient allocations reveals that the autarkic economy underinvests in production when aggregate risk is below a threshold, but overinvests in production when it is above the threshold. We show how regulatory intervention tools that are central to the debate on bank regulation—capital requirements, liquidity requirements, deposit insurance and bank bailouts financed by taxation—can be used to implement the efficient allocations in a decentralized economy. For a given efficient allocation, there is a range of regulatory policies all of which implement the allocation, but the equilibrium of the regulated economy is unique for a given regulatory policy. The various tools in an optimal regulatory policy must be finely tuned to each other. Capital and liquidity requirements move in opposing directions; an optimal regulatory policy that features a stricter capital requirement has a looser liquidity requirement. When aggregate risk is below a threshold, the efficient allocation can be implemented via deposit insurance and taxation alone. Capital and liquidity requirements are, however, necessary to ensure a unique equilibrium of the regulated economy. When aggregate risk is high, all four regulatory tools are essential components of an optimal regulatory policy. Our results provide qualified support for proponents and opponents of stricter banking regulation. Lower capital requirements for banks could be optimal, but they must be accompanied by stricter liquidity requirements and vice versa.