Rules versus Discretion in Capital Regulation

Urban Jermann and Haotian Xiang

No 33578, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E44 G21 G28 (search for similar items in EconPapers)
Date: 2025-03
Note: CF EFG
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Published as Urban Jermann & Haotian Xiang, 2025. "Rules versus discretion in capital regulation," Journal of Financial Economics, vol 169.

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