Bank Competition and Risk Taking in a Zero Interest Environment

How do near-zero interest rates affect bank competition, risk taking and financial regulation? I study these questions in a tractable dynamic general equilibrium model, in which forward-looking banks compete imperfectly for deposit funding, and deposit insurance may induce excessive risk taking. The zero lower bound on deposit rates (ZLB) distorts bank competition and boosts risk shifting incentives, particularly if rates are expected to remain near-zero for long. At the ZLB, capital regulation becomes a less effective tool to curb risk-shifting incentives. When banks cannot pass on the cost of capital to depositors, tight capital requirements erode franchise value, countervailing the usual \skin in the game" effect. Very low interest rates may therefore motivate weaker capital regulation, despite overall higher risk. The model has implications for the interplay between monetary and macro-prudential policies, and suggests that it may be desirable to complement existing regulation with policy tools that subsidize the funding cost of banks at the ZLB.