Optimal Banking Regulation with Endogenous Liquidity Provision

In a money-search model where deposits are used as means-of-payments, banks have expertise to obtain higher returns from assets with a cost and an economy of scale but are subject to limited commitment and moral hazard. They can pledge a proportion of asset holdings to issue deposits. Optimal regulation trades off efficiency in assetmanagement and liquidity service banks provide. An optimal charter system restricts banking licence to crate profits for banks to sustain a leverage ratio above the laissezfaire level to improve liquidity. A moral hazard problem for banks is also considered where banks may choose to gamble with the assets to obtain a stochastic higher private returns but with lower overall expected returns and we characterize the optimal capital requirement. As moral hazard becomes more serious, optimal regulation allows banks to be larger and have higher profits to compensate for stricter capital requirement due to moral hazard. However, we also show that when such capital requirement becomes too restrictive, it is in fact optimal to allow banks to gamble.