Designing a Banking System to Eliminate the Potential for Catastrophe

This paper identifies policies that prevent financial instability and excessive risktaking while taking into account banks’ endogenous portfolio choice and default decision. Although direct asset restrictions or market concentration can eliminate the potential for a high default risk and risk-shifting, these policies harm social welfare. Transparent banking can deregulate these policies; however, its favorable impact is offset by deposit insurance. Instead, interest rate caps and debt-type managerial compensation eliminate the potential for a catastrophic equilibrium in economic upturns and downturns, respectively. The combination of these schemes neither sacrifices social welfare nor the coverage of deposit insurance. I also find that regulators can provide banks with incentives to comply with this policy set and save the cost of monitoring business cycles to switch between the two policies by ordering banks to report business conditions. Policy implications based on the calibrated model are also proposed. ∗Address: 1126 East 59th Street, 60637, USA, e-mail: [email protected]. I would like to thank my advsiors Ali Hortaçsu, Gregor Matvos, and Zhiguo He for their help and support. I am grateful for the comments received from Anil Kashyap, Nobuhiro Kiyotaki, Casey Mulligan, and seminar participants at the 32nd International Conference of the French Finance Association, European Financial Management Association 2015 Annual Meetings, Financial Management Association 2015 Annual Meetings, Washington University in St. Louis Graduate Conference, as well as the University of Chicago Industrial Organization Working Group.