Bank capital requirements and managerial self-interest

Is there an interaction between bank capital requirements and agency problems? To which extent is the assumption of perfectly aligned bank manager–shareholders harmless? To address these questions, we consider a bank in which both a regulator–bank conflict and a shareholders–manager agency problem coexist. We analyze the effect of capital adequacy requirements on bank risk policy when managers and shareholders have different information about the quality of the loan portfolio. Taking as given optimal regulation on capital requirements and deposit insurance, we show that the separation of ownership and control in banks leads to an excessive reduction in the banks’ loan portfolio risk (underinvestment) and an increase in the managerial effort in loan supervision. We find, in fact, that only high-quality loans are taken on by banks, and some profitable investments are bypassed. Additionally, we show how bank debt and reserve requirements can help restore efficiency. Our results are related to the theoretical and empirical literature that deals with the effects of the Basle Accords on the banks’ credit policy.