Introduction

The analysis of banking regulation must start with a careful analysis of the characteristics of banking and of why regulation is needed in that industry. A growing number of economists challenge the traditional view that banking differs from other somewhat competitive industries and needs to be regulated. Meanwhile, practitioners have lost some of their earlier enthusiasm for deregulation. The S&L crisis in the US and the difficulties encountered by a number of other financial institutions have led to stricter regulatory requirements. Furthermore, the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA) by and large has removed the regulators' discretionary powers. Europe is also pondering the future of its prudential regulation. The Basle 1988 agreement on the uniformization of capital adequacy requirements has paved the way for a European Monetary Union. In both cases, there is much concern that the requirements do not take sufficient account of bank diversification or of the real riskiness of loans. It is suggested that regulators should use softer information about the quality of loans than the institutional nature of the borrowers. By depriving the requirements of their mechanical aspect, these suggestions raise the issue of who would regulate. Should this close monitoring be performed by a central bank or by private investors (main creditor, multiple creditors, rating agencies)? And should deposit insurance be privately contracted for or should it be publicly provided conditional on the bank having a high credit rating or else some government requirements being met?

This paper studies moral hazard both at the bank level and at the level of its monitors. It sets aside macroeconomic aspects of banking, which we hope to address in future work.