The Sequence of Bank Liberalisation: Financial Repression versus Capital Requirements in Russia

We model how the reduction of required reserves and the introduction of capital rules affect bank risk-taking behaviour in a financially repressed environment. In the absence of capital rules, the reduction of required reserves unambiguously encourages gambling behaviour. The introduction of capital rules only succeeds in mitigating this effect if capital is not too costly and loan default rates are not too high. We use evidence from the Russian banking sector to illustrate the model. We conclude that a moderate amount of financial repression may be preferable to capital rules for the purpose of securing systemic stability if loan default rates are high and the cost of capital is considerable, which may be the case in many emerging banking markets. Comparative Economic Studies (2008) 50, 297–317;. doi:10.1057/ces.2008.7