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Banking Regulation and Prompt Corrective Action

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  • Xavier Freixas
  • Bruno Maria Parigi

Abstract

We explore the rationale for regulatory rules that prohibit banks from developing some of their natural activities when their capital level is low, as epitomized by the US Prompt Corrective Action (PCA). This paper is built on two insights. First, in a moral hazard setting, capital requirement regulation may force banks to hold a large fraction of safe assets which, in turn, may lower their incentives to monitor risky assets. Second, agency problems may be more severe in certain asset classes than in others. Taken together, these two ideas explain why, surprisingly, capital regulation, which may cope with risk and adverse selection, is unable to address issues related to moral hazard. Hence, instead of forcing banks to hold a large fraction of safe assets, prohibiting some types of investment and allowing ample scope of investment on others may be the only way to preserve incentives and guarantee funding. In particular, providing incentives to monitor investments in the most opaque asset classes may prove to be excessively costly in terms of the required capital and thus inefficient. We show that the optimal capital regulation consists of a rule that a) allows well capitalized banks to freely invest any amount in any risky asset, b) prohibits banks with intermediate levels of capital to invest in the most opaque risky assets, and c) prohibits undercapitalized banks to invest in any risky asset.

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File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2007/wp-cesifo-2007-11/cesifo1_wp2136.pdf
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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 2136.

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Date of creation: 2007
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Handle: RePEc:ces:ceswps:_2136

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Keywords: banking; prudential regulation; moral hazard;

References

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  1. Besanko, David & Kanatas, George, 1996. "The Regulation of Bank Capital: Do Capital Standards Promote Bank Safety?," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 5(2), pages 160-183, April.
  2. Allen, Franklin & Carletti, Elena & Marquez, Robert, 2005. "Credit market competition and capital regulation," CFS Working Paper Series 2005/23, Center for Financial Studies (CFS).
  3. Gary Gorton & Andrew Winton, 2002. "Financial Intermediation," NBER Working Papers 8928, National Bureau of Economic Research, Inc.
  4. Bhattacharya, Sudipto & Plank, Manfred & Strobl, Günter & Zechner, Josef, 2000. "Bank Capital Regulation with Random Audits," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2597, C.E.P.R. Discussion Papers.
  5. George J. Benston & George G. Kaufman, 1997. "FDICIA after Five Years," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 11(3), pages 139-158, Summer.
  6. Joe Peek & Eric S. Rosengren & Geoffrey M. B. Tootell, 1999. "Is Bank Supervision Central To Central Banking?," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 114(2), pages 629-653, May.
  7. Calem, Paul & Rob, Rafael, 1999. "The Impact of Capital-Based Regulation on Bank Risk-Taking," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 8(4), pages 317-352, October.
  8. Holmström, Bengt & Tirole, Jean, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," IDEI Working Papers, Institut d'Économie Industrielle (IDEI), Toulouse 40, Institut d'Économie Industrielle (IDEI), Toulouse.
  9. Narayana Kocherlakota & Ilhyock Shim, 2005. "Forbearance and Prompt Corrective Action," Levine's Bibliography 666156000000000532, UCLA Department of Economics.
  10. Kim, Moshe & Kristiansen, Eirik Gaard & Vale, Bent, 2005. "Endogenous product differentiation in credit markets: What do borrowers pay for?," Journal of Banking & Finance, Elsevier, Elsevier, vol. 29(3), pages 681-699, March.
  11. Abel Elizalde & Rafael Repullo, 2007. "Economic and Regulatory Capital in Banking: What Is the Difference?," International Journal of Central Banking, International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 87-117, September.
  12. Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, Elsevier, vol. 36(5), pages 1137-1170, June.
  13. Aggarwal, Raj & Jacques, Kevin T., 2001. "The impact of FDICIA and prompt corrective action on bank capital and risk: Estimates using a simultaneous equations model," Journal of Banking & Finance, Elsevier, Elsevier, vol. 25(6), pages 1139-1160, June.
  14. Jones, David S. & King, Kathleen Kuester, 1995. "The implementation of prompt corrective action: An assessment," Journal of Banking & Finance, Elsevier, Elsevier, vol. 19(3-4), pages 491-510, June.
  15. Aghion, Philippe & Bolton, Patrick, 1997. "A Theory of Trickle-Down Growth and Development," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 64(2), pages 151-72, April.
  16. Allen N. Berger & Sally M. Davies & Mark J. Flannery, 2000. "Comparing market and supervisory assessments of bank performance: who knows what when?," Proceedings, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, pages 641-670.
  17. Piketty, Thomas, 1997. "The Dynamics of the Wealth Distribution and the Interest Rate with Credit Rationing," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 64(2), pages 173-89, April.
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Cited by:
  1. J.-P. Niinimäki, 2012. "Optimal Design of Bank Bailouts: The Case of Prompt Corrective Action," Finnish Economic Papers, Finnish Economic Association, Finnish Economic Association, vol. 25(1), pages 1-19, Spring.

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