Looting and Gambling in Banking Crises∗

We construct a model of the banking firm and use it to study bank behavior and bank regulatory policy during crises. In our model, dur-ing a crisis a bank can increase the risk of its asset portfolio (“risk shift”), convert bank assets to the personal benefit of the bank man-ager (“loot”), or do both. Each action is socially costly. To mitigate such actions, a regulator has three policy tools: it can impose a penalty on risk-shifting; it can impose a penalty on looting; and it can force banks to hold more equity capital. All policies must be implemented before anyone knows if there will be a crisis. Our paper contains three important policy lessons. First, enforc-ing property rights and punishing theft is the policy that works best and has the fewest side effects. Second, trying to prohibit the bank manager from taking risk may backfire, he may switch to even riskier strategies. Third, there is a conflict of interest between inside and outside equity; outside equity induces looting