Liberalization, Moral Hazard,
and Prudential Regulation
Are Capital Requirements Enough?
Joseph E. Stiglitz
Senior Vice President and Chief Economist
The World Bank
Siena, Italy
Why Prudential Regulation ?
• Banking crises are common and costly
– Over 80 crises episodes in last two decades
– Costs range up to 40% of GDP
• Prudential regulation is specifically designed to
prevent such crises
Prudential Regulation Methods
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Monitoring of individual transactions
Regulations concerning self-dealing
Capital requirements
Entry restrictions
In some countries, interest rate restrictions
Recent Changes in Prudential
Regulation Systems
•Financial liberalization
•Interest rate deregulation
•Asset regulation lifted
•Basle Accord
•Greater emphasis on capital requirements
•Greater emphasis on risk management systems
•Less monitoring of individual transactions
Theoretical Links between
Liberalization and Greater
Frequency of Crises
• Liberalization increases competition
• Competition erodes profits
• Lower profits=> lower franchise value =>
lower incentives for making good loans
• Increased incentive to gamble. Moral
hazard problem thus exacerbated.
Do Capital Requirements Offset
Adverse Effects of Liberalization?
• If banks hold sufficient capital, adverse
consequences of gambling internalized
• Moral hazard is mitigated, but banks forced
to hold inefficiently high amount of capital
Pareto Efficiency Impossible With
Only Capital Requirements
• Along Pareto frontier, all competitors are
efficient and total profit earned identical
• But offering higher rates captures additional
deposits
• Higher rates possible only by gambling on
higher margin of profit
• Thus, market stealing effect =>incentive to
deviate from Pareto equilibrium
Pareto Efficient Outcomes Achieved By
Both Deposit Rate Control And Capital
Requirements
• Deposit rate ceilings preclude banks from
competing through inefficiently high deposit
rates
• Deposit rate ceilings increase franchise value
and sustain prudent bank behavior
Other Instruments May Also
Improve Prudential Regulation
• Asset class restrictions
• Entry restrictions
• Direct supervision enhancement
Conclusion
• Liberalization increases likelihood of crises
and increases moral hazard
• Capital requirements alone do not mitigate
adverse consequences
• Capital requirements and deposit rate
ceiling combination can achieve Pareto
efficient outcome.