We construct a model of the banking firm with inside and outside equity and use it to study bank behavior and regulatory policy during crises. In our model, a bank can increase the risk of its asset portfolio ("risk shift"), convert bank assets to the personal benefit of the bank manager ("loot"), or do both. A regulator has three policy tools: it can restrict the bank's investment choices; it can make looting more costly; and it can force banks to hold more equity. Capital regulation may increase looting, and in extreme cases even risk shifting. Looting penalties reduce both looting and risk-shifting.
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- Asset substitution
- Risk shifting