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Economic Quarterly

Summer 2001

Regulating Bank Capital Structure to Control Risk

Edward S. Prescott

Since the Basle capital regulations of 1988 and the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, capital requirements have been a critical part of bank regulation. These requirements limit leverage by requiring and encouraging banks to hold minimum levels of equity. This article uses the agency theory of corporate finance to study how capital requirements control bank risk taking. It finds that existing capital regulations can be made more effective if augmented with financial instruments like warrants or convertible debt.

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