Capital requirement and financial stability

Abstract

[ACCESS RESTRICTED TO THE UNIVERSITY OF MISSOURI AT AUTHOR'S REQUEST.] This dissertation consists of two chapters. In the first chapter, I examine the tradeoff between bank competition and financial stability resulting from the capital requirement when an unexpected bank run may happen. Built on the framework of Diamond-Dybvig, the model shows that a higher capital requirement tightens banks' capacity for taking deposits, thus reducing the intensity of competition between banks and at the same time improving financial stability. However, the total effect of capital requirement on welfare is not monotone. The second chapter extends the work of the first chapter and shows that in an environment where run is expected ex ante, sufficient capital and optimally set capital requirement can still achieve first-best allocation, thus run probability will not matter if the capital requirement is optimally chosen. A bank's contracts in economies with different run probabilities are also examined.