#05-11
Notes on Optimal Capital Regulation
Douglas Gale
Abstract: Capital adequacy requirements are justified on two grounds. On the one
hand, equity capital reduces the incentive for excessive risk taking (asset
subsitution or risk-shifting behavior). On the other, it provides a buffer that
offsets a shortfall in the realized value of assets and allows the orderly disposal
of assets in the event of bankruptcy. This paper presents a simple
model of capital as a buffer stock, in which the optimal capital structure
improves risk sharing between shareholders and depositors. In this framework,
we can illustrate a number of general properties of optimal capital
structure. First, capital structure is irrelevant when markets are complete.
Second, even if markets are incomplete, the privately optimal level of capital
chosen by financial institutions may be socially optimal. In that case, there is
no rationale for intervention by the authorities to regulate capital structure.
Third, the laisser-faire equilibrium may be inefficient if there is heterogeneity
among institutions and the markets for sharing risk among institutions
are incomplete or absent. However, even if the capital structure chosen in
equilibrium is inefficient, it does not necessarily follow that minimum capital
requirements will improve matters: there may be too much or too little
capital in equilibrium. We extend the basic model to allow for heterogeneity
among financial institutions, characterize the impact of capital regulation in
this case and consider the alternatives to capital regulation.
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