Bank capital structure and regulation: Overcoming and embracing adverse selection

We study bank regulation under optimal contracting, absent exogenous distortions. In equilibrium, banks offer a senior claim (deposits) to external investors and retain equity; the return on equity is higher than the return on deposits due to a scarcity of skilled bankers. Inefficient equilibria emerge under asymmetric information. Optimally designed regulation restores efficiency. Our main result is that disclosure requirements by themselves can be endogenously costly because they may push the economy from a separating equilibrium to a less efficient equilibrium that pools good and bad banks, but always improve welfare when combined with capital regulation.