CAPITAL CONTROLS AND BANK RISK

We analyze the effects of deposit guarantees on banks' loan portfolio. In contrast to earlier work, we view bank loans net of evaluation and monitoring costs as non-zero NPV investments (e.g. market securities). Deposit guarantees lead to inefficient investment and under plausible circumstances capital requirement increases lead banks to increase asset risk. The risk increase reduces the beneficial effects of capital increases on the probability of default and on the economic efficiency of bank lending. In some cases, a tightening of the capital constraint even leads to an increase in the probability of default and financial instability, and to higher expected costs of transferring assets to regulatory agencies. Increases in bank capital are not a substitute for risk monitoring and control and may imply an increased need for such surveillance. © 1991.