Prescott A moral hazard model with exogenous bank franchise value is used to analyze bank capital regulation.
Banks choose their capital structure as well as the riskiness and mean of their portfolio.
The portfolio mean is determined by the level of costly screening. Screening and portfolio risk are private information, so there are two dimensions to the moral hazard problem. To mitigate these incentives, capital requirements with and without ex post fines are studied. Adding state-contingent regulation can significantly lower capital requirements. For further information, see instructions for using Adobe Acrobat files.