Assessing the Pre‐Commitment Approach to Bank Capital Regulation Available to Purchase

The pre‐commitment approach to bank capital regulation proposes that banks self‐select capital reserve requirements, facing penalties ex post for incurring losses in excess of reserves, hence providing incentives for high‐ risk banks to choose higher capital requirements. In order to assess the validity of the pre‐commitment approach, this article analyzes its comparative statics within the context of a standard European option written against the bank's capital base. The author finds that this approach works when it is not needed (when banks possess unlimited capital and hence cannot fail), but not when it is.