Is the relation between capital adequacy and the stability of the banking system everlasting?

In the banking regulation literature, a permanent positive relation between capital adequacy and the stability of the banking system is accepted. This paper suggests that in an imperfect deposit market structure with heterogeneous banks, increasing regulatory capital may not necessarily lead to its main objective, which is to improve the stability of the banking system. It also shows that stability in the banking system and equity capital regulations, is closely related to the allocation efficiency and the distribution of bank income among depositors and shareholders, and pursuing higher regulatory equity capital policy is likely to deteriorate the allocation efficiency of the banking system. Specifically, the effects of these policies on allocation and stabilization efficiency will be explored in terms of the types of conceivable equilibria for deposit rates, share of deposit market, expected net returns, expected markup, and the level of expected effort of banks operating in the banking system.

Keywords:

Imperfect competitive market , banking system stability , regulation , contagion risk