Bank Regulation, Investment, and Capital Requirements Under Adverse Selection

Abstract

This paper studies the optimal design of bank capital regulations when capital markets are subject to adverse selection. In this setting, the regulator faces a trade-off between enhancing financial stability and inducing investment in socially valuable projects. We show how the implementation of capital requirements can eliminate the information frictions that make raising capital costly by inducing banks to reveal their private information to the market. Importantly, under this approach the regulator faces an entirely different objective and trade-off when compared to setting capital requirements that do not reveal bank information. We solve for the optimal regulations which induce information revelation via recapitalization programs when the banking sector is weak and pool the banks' private information via uniform capital requirements otherwise. Optimal capital requirements are linked to the securities issued to meet them, demonstrating potential welfare gains from allowing less informationally sensitive securities (e.g. contingent convertible bonds) to qualify as bank capital. (JEL D82, G21, G28)