OPTIMAL REGULATION OF DEPOSIT TAKING FINANCIAL-INTERMEDIARIES

This paper analyses the case for special restrictions on the commercial decisions of deposit taking financial intermediaries. The existence of asymmetric information between managers of intermediaries and depositors is shown to generate unregulated outcomes where equity capital is 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 regulators. This is an important result because such schemes have lacked a theoretical underpinning. Even those who have viewed capital requirements as justifiable have assumed that they will reduce the level of intermediation; this paper shows that this is not generally the case. The ways in which optimal capital adequacy rules differ from the regulations currently used by banking supervisors is also analysed.