OPTIMAL REGULATION OF DEPOSIT TAKING FINANCIAL-INTERMEDIARIES

This paper analyses the case for special restrictions on the commercia l decisions of deposit taking financial intermediaries. The existence of asymmetric information between managers of intermediaries and depos itors is shown to generate unregulated outcomes where equity capital i s underutilised and lending is suboptimally low. A form of regulation to correct this market failure is designed. The form of regulation is a capital adequacy scheme of the same kind as those used by bank regul ators. This is an important result because such schemes have lacked a theoretical underpinning. Even those who have viewed capital requireme nts as justifiable have assumed that they will reduce the level of int ermediation; this paper shows that this is not generally the case. The ways in which optimal capital adequacy rules differ from the regulati ons currently used by banking supervisors is also analysed.