Capital adequacy requirements, deposit insurance and bank behaviour

Abstract

As financial market regulations have been eliminated over the past decade, the fragility of the international financial system has been exposed. In turn, this has generated interest in the design of prudential regulations and safety net procedures for banks. In this paper the thesis is advanced that the two must be treated as interdependent and not substitutes. A capital adequacy requirement ensures that there is a buffer against a decline in the value of bank assets. However, it does not eliminate the possibility of runs. On the other hand, deposit insurance creates a moral hazard problem which can best be limited by setting appropriate capital requirements and risk weights.