Bank capital regulation with and without state-contingent penalties

We study bank capital regulation using a two-dimensional moral-hazard model. Banks choose capital and portfolio risk. They also choose their level of costly screening, which determines their mean portfolio return. Screening and risk are private information. Deposit insurance gives low franchise-value banks an incentive to choose a suboptimally high level of risk and a suboptimally low level of screening. Ex ante capital regulation can mitigate this problem. Optimal capital requirements are generally non-monotonic in franchise value. Adding ex post fines to capital requirements improves welfare by significantly reducing the use of costly capital. Optimal fine schedules are characterized by fines on the extreme right-hand tail of the return distribution.