1. ^aCenter for Financial Research, Federal Deposit Insurance Corporation, Washington DC, U.S.A.
2. ^bSchool of Accounting and Finance, Roosevelt University, Chicago, IL, U.S.A. E-mail: dnickerson@roosevelt.edu

Abstract

Differences in the portfolios of depositories and insurance and reinsurance firms are important for the design of efficient capital regulations. Using a simple contingent claims model which focuses on credit risk and in which intermediaries issue liabilities under conditions of moral hazard, we illustrate three effects of risk-based capital regulations on institutional solvency risk, liquidity and economic efficiency. First, assuming identical asset risks to depositories, insurers that issue significant amounts of contingent liabilities may exhibit a zero risk of insolvency while holding significantly less equity capital than depositories. Second, higher capital requirements must be placed on depositories to attain the same degree of solvency risk, owing to the riskless payoffs promised for bank deposits and similar liabilities. Third, while bank-based capital regulations cannot resolve losses associated with systemic financial risk, capital regulations that incorporate incentive-compatible tax penalties to mitigate moral hazard effects can do so by increasing both liquidity and spanning. We conclude that distortions occur when measuring the solvency risk of insurers and other non-bank intermediaries with bank-based capital regulations and that uniform harmonization of capital regulations across depositories and insurers can significantly reduce aggregate liquidity and efficiency.