Banking in a theory of the business cycle: a model and critique of the Basle Accord on risk-based capital requirements for banks

This paper presents a theoretical framework for understanding the investment decisions and financing decisions of financial and non-financial enterprises over the business cycle. At the core of this theoretical framework is an agency problem between relatively more risk averse depositor/bondholders and relatively less risk averse stockholders. The solution to this agency problem is a corporate governance system that takes the form of an up-front contract that directs managers to make portfolio/investment decisions in the interest of their stockholders, and financing decisions in the interest of their depositor/bondholders. This enables depositor/bondholders to offset any risk shifting portfolio/investment decisions made on behalf of the shareholders thereby mitigating the moral hazard problem among debtors and creditors. The Basle Accord on risk-based capital requirements for depository institutions is one particular regulatory application of this more general theoretical framework. The paper concludes with a comparison between the Basle Accord and the 100% reserve or narrow banking proposal as the means of achieving a risk-free medium of exchange and a financial system that facilitates the optimal transfer of resources from savers to investors consistent with society’s aversion towards risk.