The role of prudential supervision in a regulated banking industry
AbstractThis study considers the optimal regulation of a single bank that has private information on the intrinsic quality of its loan portfolio (adverse selection) and where the bank's choice of effort to improve this quality cannot be observed by the banking regulator (moral hazard). In designing optimal contracts the regulator faces a tradeoff between inducing proper incentives for efficient banking and costs of regulation in terms of leaving an informational rent for a high quality bank. As a consequence, the instability of the banking sector increases. To resolve the informational asymmetries the regulator may require the help of a supervising agency, allowing to impose penalties on a bank's management when caught shirking. However, since improving the accuracy of supervision is costly, even in the optimal monitoring scheme there generally exists a positive probability of bankruptcy. Hence, full information disclosure in the sense of improving the supervisor's accuracy to the fullest need not be optimal for the regulator.
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Bibliographic InfoPaper provided by Netherlands Central Bank, Research Department in its series WO Research Memoranda (discontinued) with number 594.
Date of creation: 1999
Date of revision:
adverse selection; moral hazard; optimal incentive contracts; supervision;
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