let bank management, bank directors and bank creditors off the hook by, in essence, providing a warrant of fitness for the model and the bank? in order to evaluate the proposals, we should go back to first principles. the case for regulating bank capital is there a case for a country to specify minimum levels of capital which banks should hold? no such requirements exist for pharmaceutical companies, software vendors or telecommunications providers, where failure might impose externalities which would actually be life threatening. the fact that banks are risky ventures that go bust from time to time does not alone justify that minimum capital standards should be imposed. the traditional case for regulating banks in order to reduce the probability that they might bust is that when depositors see a bank go bust they act in fear and ignorance as to the true condition of all other banks. they run to their own bank to be first in line to withdraw deposits and in so doing may force a perfectly sound bank to run out of liquid assets, sell sound assets at a discount and so become insolvent. the combination of asymmetric information about the credits created ( depositors can not know the state of the bank's borrowers ), the sequential service constraint ( all on demand deposits can be withdrawn in full ), and the liquidity transformation services provided by banks ( short term deposits finance long term loans ) makes banks inherently vulnerable to a loss of confidence. further, banks often borrow from and lend to each other both in the short - term money markets and through the payment system. thus, the failure of one bank may indeed pose a threat to the solvency of another, even absent a run by depositors. banks will hold liquid assets and capital at levels high enough to meet some subjective assessment of the probability of runs and counterparty failures. an alternative argument used to justify bank regulation is that in a system where central banks are called on to provide lender of last resort facilities to solvent but illiquid banks, in order to distinguish solvent from insolvent banks the central bank should undertake on - site examinations to establish the state of each institution. the prospect of system - wide contagion, in which society is denied the liquidity transformation and credit origination services of the banking industry, provides the soundest basis for regulating banks and socialising the costs of individual bank failures. the objective in socialising losses is to preserve services for future savers, borrowers and transactors, but the consequence is to protect current depositors from facing losses

##crat. determining the optimal level of bank capital let us set aside the issues facing the solvent but illiquid bank by assuming a central bank has the capacity to act as lender of last resort. this presumes the central bank will be able to distinguish an illiquid but solvent bank from an illiquid and insolvent one. let us focus on : · how banks might determine the privately optimal amount of capital to hold ; · some factors which might cause the socially optimal amount of bank capital to diverge from the private optimum ; and · strategies to cause convergence between the socially and the privately optimal level of capital. because bank management might have misjudged the quality of its borrowers, because economic circumstances may cause once sound borrowers to fail and because depositors might withdraw funds earlier than expected, necessitating asset liquidations at discount rates above expected yield to maturity, bank management ( wishing to preserve their jobs ) and bank shareholders ( wishing to preserve the franchise value of their business ), will find it optimal to hold some capital. that is, to retain within the bank assets with an expected net present value in excess of the net present value of liabilities. but by how much? if too little capital is held, the probability of failure is too high ; if too much capital is held, the rate of return on equity is less than it might be. surely this is an equilibrating mechanism where depositors'interests are protected by shareholder and management incentives to preserve the bank? those who advocate a return to free banking would argue so. and did not modigliani and miller show nearly 50 years ago that debt / equity ratios do not influence the value of the firm? well at least in frictionless markets with complete information and no taxes. let us set aside the traditional argument in favour of bank regulation – that banks are opaque, depositors need agents to monitor the bank on their behalf, and regulators can do this cost effectively. let us set aside the strongest argument for regulation – the prospect of contagion. let us assume complete markets and symmetric information and that depositors, shareholders and bank management seek to maximise the expected value of their interests. in this world, let us assume there is an unnatural person with full contractual capacity and limited liability. that is, payoffs are asymmetric. this unnatural person is a bank and i contend it will seek to hold less than the socially optimal level of capital. depositors earn high