Dynamic Prudential Regulation

We investigate the design of prudential bank regulation and its eects on the real and financial decisions of banks in a continuous-time structural framework. In our model, the regulator controls the dynamic risk-shifting incentives of a representative bank through the threat of intervention in the bank’s operations. The optimal regulatory policy, which we characterize analytically, entails an optimal combination of a capital requirement, intervention to control the risk of the bank’s portfolio, capital injection, and liquidation of the bank. Under the optimal risk intervention policy, the regulator intervenes when the bank’s capital ratio lies inside a “band” consisting of two triggers. We calibrate the model and show that the optimal capital requirement is 23%, which supports the substantially higher capital requirements being proposed in the Basel III accords. Relative to a benchmark unregulated bank, regulation increases bank leverage by 12%, while lowering its credit spread. Capital injection or risk intervention alone has modest impact on the bank’s social value. The optimal combination of regulatory policies, however, significantly improves social value by 4% and bank value by 11%. Optimal capital requirements should be counter-cyclical and should be stricter for large banks. Optimal regulation is also significantly aected by monetary and fiscal policies. Overall, our analysis highlights the importance of considering the interactions among dierent individual regulatory