Bank regulation, investment, and capital requirements under adverse selection

Thomas J Rivera

Review of Finance, 2025, vol. 29, issue 2, 415-465

Abstract: This article studies the optimal design of bank capital regulations when capital markets are subject to adverse selection. I show how the implementation of capital requirements can eliminate the information frictions that make raising capital costly by screening banks to reveal their private information to the market. The optimal regulations induce information revelation via recapitalization programs when the banking sector is weak and pool the banks’ private information via uniform capital requirements otherwise. Optimal capital requirements are linked to the securities issued to meet them, demonstrating potential welfare gains from incorporating more and less informationally sensitive securities into the design of capital regulations. Finally, the analysis generates insights into the joint design of equity capital requirements and additional tier 1 capital securities.

Keywords: capital requirements; adverse selection; investment; security design (search for similar items in EconPapers)
JEL-codes: D82 G21 G28 (search for similar items in EconPapers)
Date: 2025
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