European Economic Review 50 (2006) 509–516 Optimal regulation of deposit taking financial intermediaries: A correction Alistair Milne à Faculty of Finance, Cass Business School, City University, 106 Bunhill Row, London EC1Y 8TZ, UK Received 15 February 1999; accepted 15 April 2004 Available online 25 November 2004 Abstract This paper corrects a paper of David Miles, published in the European Economic Review in 1995, reversing some of the conclusions he draws. Solving his model correctly it turns out that, because depositors are unable to monitor the default risk of individual banks, moral hazard gives banks an incentive to increase risky lending. Prudential capital requirements reduce incentives to hold risky loans. r 2004 Elsevier B.V. All rights reserved. JEL classification: G28 Keywords: Bank regulation; Moral hazard 1. Introduction Miles (1995), in the European Economic Review, offers a model of bank intermediation with the following distinguishing features: 1  Banks are monopoly suppliers of loans to their own customers. The quantity of their lending L has no impact on the loan business of other banks. Banks hold no assets other than loans. ARTICLE IN PRESS www.elsevier.com/locate/econbase 0278-4319/$ - see front matter r 2004 Elsevier B.V. All rights reserved. doi:10.1016/j.euroecorev.2004.09.001 à Tel.: +44 (0)20 7040 8738; fax: +44 (0)20 7040 8881. E-mail address: amilne@city.ac.uk (A. Milne). 1 Taggart and Greenbaum (1978) analyse a model of bank behaviour with a similar structure to Miles (1995), but without the assumption of asymmetric information.