Journal of Economic Literature 2014, 52(1), 197-210

201

Myerson: Rethinking the Principles of Bank Regulation

equity by treating interest payments more 

favorably than dividend payments. Such 

provisions in the tax code increase the fra-

gility of the financial system by encouraging 

corporations to use more debt instead of 

equity in financing investments. This effect 

is especially perverse when applied to bank-

ing, where capital regulation then must act 

to reverse it.

 When equity is too small, the possibility of 

default can begin to distort investment deci-

sions in the bank. When evaluating a poten-

tial new investment, the bank’s owners would 

put no value on any prospective returns from 

the investment that would accrue after the 

event of the bank’s failure, as any returns 

in this event would only benefit the bank’s 

creditors. Thus, the possibility of default 

can reduce the bank’s willingness to make 

productive investments from retained earn-

ings. Conversely, the bank’s willingness to 

take risks with borrowed funds may increase. 

Once there is some serious possibility of the 

bank’s equity being wiped out by losses in its 

investments, any additional losses will not 

affect the bank owners, since they cannot 

get less than zero from their equity shares 

in the bank. Additional losses would then be 

borne by the creditors (or by the taxpayers 

who guarantee the creditors), but the owners 

who control the bank have no incentive to 

take these downside risks into account. Thus, 

a bank with insufficient equity has distorted 

incentives that can encourage its owners to 

take excessive risks or gamble for resurrec-

tion (as in “heads our equity value rises, tails 

the creditors lose more”).

Admati and Hellwig call these distorted 

incentives for underinvestment and exces-

sive risk taking the “dark side of borrowing.” 

Notice that the problem of equity owners 

undervaluing prospective returns in the 

event of default does not depend on deposit 

insurance; it can arise in any corporation with 

a given burden of debt that is large enough 

to create a substantial possibility of default 

(see Myers 1977). Deposit insurance can 

exacerbate the problem, however, by making 

the cost of new borrowing insensitive to pro-

spective returns in the event of default.

Unfortunately, when the time comes that 

investment losses begin to deplete the bank’s 

equity, the bank may not have the right 

incentives to raise new equity. If the bank 

were to increase its capital by selling new 

equity shares, the result would be to transfer 

to the owners some of the downside risks that 

are being borne by the creditors, so the net 

value of the existing owners’ shares would 

be decreased. Thus, as Admati and Hellwig 

emphasize, borrowing can become addic-

tive, as the primary advantages of increas-

ing the ratio of equity to debt would accrue 

to the creditors, but not to the owners who 

control the bank. The bank’s long-term abil-

ity to attract deposits may depend on a com-

mitment to force the bank to increase equity 

when it becomes too small. Thus, for long-

term sustainability, a bank needs regulation.

3.  Capital, Liquidity, and Lenders of  

Last Resort

 Before the 1980s, bank regulation focused 

more on liquidity reserves than on equity 

capital. Gorton (2012) has expressed some 

concern about the focus on capital require-

ments, rather than liquidity requirements. 

But Admati and Hellwig, while criticizing 

the parameters of current capital regulation, 

support the focus on equity capital itself. To 

see the logic of this position, we must con-

sider the basic function of a central bank in 

the economy. The basic idea is that a central 

bank should be able to solve general liquid-

ity problems in the banking system as long 

as banks have adequate capital or equity. 

Let me try, in this section, to enlarge on this 

point so as to indicate the fundamental infor-

mational nature of the problem.

The primary liquidity requirement for 

banks has been that they should hold some 

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Journal of Economic Literature, Vol. LII (March 2014)

202

fraction of cash or safe government bonds 

against their deposit liabilities. A bank’s cash 

reserve does not have any logical relationship 

with its equity value. On the  balance sheet, 

cash is just one asset in which a bank can 

invest—one that typically has a low expected 

return, as it generally pays little or no inter-

est. As legal tender, however, cash is the 

most liquid store of value, the one that can 

be immediately used to pay out on the bank’s 

obligations. Other investments with higher 

expected rates of return must typically be 

held over some period of time to yield their 

returns. But if a bank holds good long-term 

investments, then it should generally be able 

to sell some portion of these investments to 

other investors when it needs more cash to 

meet its obligations. To understand why illi-

quidity could sometimes be a problem, then, 

we need to understand why a bank might 

sometimes be unable to quickly liquidate 

some investments when it needs cash.

This illiquidity problem could occur if 

the bank has special expertise in evaluat-

ing its long-term investments. Then, when 

it tries to sell long-term investments early, 

other investors might infer that the bank 

got bad news about the prospective future 

returns from these investments, so the bank 

with special expertise may find that it can 

only sell its investments early at a value 

much lower than what they would expect to 

earn at maturity. That is, liquidity problems 

may be fundamentally informational, but 

informational problems are why we need 

a banking system in the first place. People 

lend their savings to banks and other finan-

cial institutions for investment because the 

banks have better information about how to 

find good investments.

Thus, liquidity for long-term economic 

investments can depend on the existence 

of other financial institutions that have the 

ability to evaluate the investments’ qual-

ity and can bid competitively to buy them. 

The critical macroeconomic problem is the  

 possibility of a general panic in which there is 

a loss of confidence in such financial institu-

tions. In case of such a panic, there would be 

a general surplus of good quality  investments 

offered for sale at a loss. But then, a “lender 

of last resort” should be able to buy up these 

discounted assets and expect some positive 

long-term profit in providing short-term 

liquidity to the beleaguered banks.

This is the basic logic of central bank-

ing, where the central bank is the financial 

system’s lender of last resort. The classic 

prescription of Bagehot (1873) is that, in a 

financial crisis when banks are generally 

short of cash, the central bank should stand 

ready to lend unlimited amounts (at a high 

interest rate), but only to solvent banks that 

have good collateral worth more than their 

liabilities. To do its job, then, the central 

bank needs more than just a deep ability to 

issue more money when necessary; it also 

needs some basic expertise in evaluating 

financial investments, so that it can identify 

when a bank’s investments can be taken as 

good collateral.

2

 In this sense, a lender of last 

resort may be better understood as a moni-

tor of last resort, and its bold lending then 

serves as public signal that the borrowing 

banks have been found creditworthy by the 

experts at the central bank. Thus, the cen-

tral bank should be able to solve the liquid-

ity problem for banks, but only when they 

are solvent, where solvency means that the 

value of the bank’s equity is positive. From 

this perspective, we see that capital regula-

tion is fundamental to liquidity, but also that 

a central bank’s ability to apply stress tests to 

evaluate the solvency of banks is as essential 

to the central bank’s function as its ability to 

print money.

2 

This expertise must be complemented (perhaps in 

another agency) by reliable expertise in the resolution of 

insolvent banks; that is, in selling or reorganizing their 

assets and operations to achieve the greatest possible value.

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