Rules versus discretion in capital regulation

Urban Jermann and Haotian Xiang

Journal of Financial Economics, 2025, vol. 169, issue C

Abstract: We study capital regulation in a dynamic model for bank deposits. Capital regulation addresses banks’ incentive for excessive leverage that dilutes depositors, but preserves some dilution to reduce bank defaults. We show theoretically that capital regulation is subject to a time inconsistency problem. In a model with non-maturing deposits where optimal withdrawals make deposits endogenously long-term, we find commitment to have important effects on the optimal level and cyclicality of capital adequacy. Our results call for a systematic framework that limits capital regulators’ discretion.

Keywords: Capital regulation; Time inconsistency; Non-maturing deposits; Dilution (search for similar items in EconPapers)
JEL-codes: E44 G21 G28 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:169:y:2025:i:c:s0304405x25000686

DOI: 10.1016/j.jfineco.2025.104060

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