Does Asymmetric Information Justify Bank Capital Adequacy Regulation

Abstract

One of the more important developments in 20th-century central banking is the rise of capital adequacy regulation—the imposition by regulators of minimum capital standards on financial institutions. Most bank regulators see capital adequacy regulation as a means of strengthening the safety and soundness of the banking system, and many see it as a useful—perhaps even necessary—response to the moral hazard problems created by deposit insurance and the existence of a lender of last resort to assist banks in difficulties. If deposit insurance and a lender of last resort encourage banks to take excessive risks and run down their capital, then forcing banks to strengthen their capital positions is a fairly obvious regulatory response. As a result, the regulation of bank capital adequacy has come to be one of the most important concerns of any modern central bank. Indeed, much of the case for modern central banking now depends on the justification (or otherwise) for capital adequacy regulation. Yet arguments for capital adequacy regulation are relatively sparse and not particularly convincing.1 Perhaps the most important argument