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I. INTRODUCTION
A sufficient condition for the social desirability of the regulation of depository intermediaries is that it improves the allocational efficiency of financial markets. The effectiveness of regulation in doing so can only be evaluated in terms of well specified objectives. A model developed to explore the effectiveness of regulation must in turn be sensitive to these objectives.
The current regulatory environment has four broad categories of restrictions related to bank safety and soundness: (1) Balance sheet restrictions; (2) Leverage restrictions, i.e., capital adequacy; (3) Anti-competitiveness measures; (4) Deposit insurance and risk taxes, i.e., variable insurance premia. A model specification must be consistent with these restrictions. Thus, categories (1) and (2) require that the intermediary make investment and financing decisions, respectively. Category (3) necessitates that non-monopolistic markets prevail in the absence of regulation. Category (4) eliminates the riskiness of certain liabilities.
In what follows, the need for all soundness regulation is assumed to arise from the desire to provide riskless assets to economic agents in the most cost effective manner.(1) This assertion is internally consistent as an objective and externally compatible with the observed regulatory framework.
The typical portfolio models of depository intermediaries (Blair and Heggestead (1978), Hart and Jaffe (1974), and Kahane (1977)) assume that no riskless asset exists from the perspective of depositors. This assumption is inconsistent with the existence of deposit insurance, and also precludes pure leverage decisions. Such a specification implies that the intermediary is essentially an arbitrageur, while the additional assumption of risk-averse behavior is needed to limit the scale of operations. Abstracting from transactions/information costs (Benston and Smith (1976), why suppliers of capital would allow arbitrage is unclear. Further, while a limited scale of btisiness is a cost measure which may be consistent with a low risk exposure, risk aversion is not a necessary condition. Sufficient model assumptions are: (1) The depository institution is a one-period value inaximizer interested only in the probability distribution of returns.(2) (2) The intermediary will only select non-stochastically dominated portfolios for a finite number of moments. For expositional convenience, terminal wealth is assumed normal. (3) Initial capital, K sub O , is fixed and greater than zero.(3)
R is the net riskless rate of return, and E pi! and sigma sub pi...