In a dynamic model of moral hazard, competition can undermine prudent bank behavior. While capital-requirement regulation can induce prudent behavior, the policy yields Pareto-inefficient outcomes. Capital requirements reduce gambling incentives by putting bank equity at risk. However, they also have a perverse effect of harming banks' franchise values, thus encouraging gambling. Pareto-efficient outcomes can be achieved by adding deposit-rate controls as a regulatory instrument, since they

more »

... litate prudent investment by increasing franchise values. Even if deposit-rate ceilings are not binding on the equilibrium path, they may be useful in deterring gambling off the equilibrium path. (JEL G2. E4, L5) Banking crises are pervasive. In the last two decades, the frequency of severe banking crises has increased significantly. Banking crises are important not just because of the devastation that they bring to one particular sector of the economy, but because typically the shock waves affect the entire economy. In the nineteenth century, most of the U.S. economy's economic downturns were related to financial panics. The budgetary consequences for governments, which often bear a significant part of tbe costs of the bailout, cannot be ignored either. A compilation of cases over tbe past two decades by the World Bank shows costs ranging up to 40 percent of GDP. Probably the best known examples are the savings and loan * Helltnann: Graduate School of Business, Stanford University, Stanford, CA 94305: Murdock: