Bank regulation when both deposit rate control and capital requirements are socially costly

A large literature on the regulation of banks has explained deposit rate control (ceilings) and capital requirements as alternative regulatory instruments for reducing moral hazard issues (i.e. the propensity of banks to take too large risks). Over the last 30-40 years, almost uniformly, regulators have moved from regimes relying on the former instrument to ones using the latter. Hitherto the theoretical literature does not seem to offer much support for this policy change whereas our contribution seeks to establish a real trade-off between the two regulatory regimes. In our model, which is an adaptation of that of Repullo (2004), the deadweight loss of capital control is its higher opportunity cost as compared to the returns derived from normal banking activities. There are several potential costs associated with deposit rate ceilings, but inspired by the observed consolidation of the banking sector after the liberalization that took place in the eighties, we focus on one: the tendency towards excess entry in the banking sector. While historically, and unlike in our stylized model, entry was not free for banks, we argue that the excess profits associated with deposit rate ceilings are likely to have put (political) pressure on regulators to allow an increased number of banks, with associated costs for society. We show that, with the trade-off as described above, and depending on the parameter configuration, each of the two regimes may welfare-dominate the other.