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Bank Regulation, Investment, and the Implementation of Capital Requirements

We study the optimal design of bank capital regulations in a model where banks face adverse selection when raising capital. We show how the implementation of capital requirements can help mitigate bank underinvestment by eliminating the information frictions that make raising capital costly. Specifically, the regulator can design incentive compatible capital requirements that induce the banks to reveal their private information to the market through their choice of capital structure. Using this insight we characterize the optimal design of capital requirements which induce such information revelation when the banking sector is weak and pool the banks' private information otherwise.