Dynamic prudential regulation: Is prompt corrective action optimal?
AbstractPrompt Corrective Action (PCA) prescribes prompt and deterministic termination of banks with insufficient levels of book-value capital. This paper investigates whether reliance on book-value capital is a good policy choice and if PCA is an optimal regulatory approach. I use a variant of DeMarzo and Fishman's (2004) dynamic model of entrepreneurial finance to model interactions between a banker and a regulator. Under hidden choice of risk, private information on returns, limited commitment by the banker and costly liquidation, I first characterize the optimal incentive-feasible allocation, and then demonstrate that the optimal allocation is implementable through the combination of a risk-based deposit insurance premium and a book-value capital regulation with prompt and stochastic termination/bailout rather than deterministic termination with no bailout as in PCA. I also show that partial termination can be used instead of stochastic termination.
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Bibliographic InfoPaper provided by Bank for International Settlements in its series BIS Working Papers with number 206.
Length: 64 pages
Date of creation: May 2006
Date of revision:
Bank Capital Regulation; Prompt Corrective Action; Risk-based Deposit Insurance Premium; Dynamic Contracts; Mechanism Design;
Find related papers by JEL classification:
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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