Prudent Banks and Creative Mimics: Can We Tell the Difference?
AbstractThe recent financial crisis has forced a rethink of banking regulation and supervision and the role of financial innovation. This paper develops a model where prudent banks may signal their type through high capital ratios. Capital regulation may ensure separation in equilibrium, but deposit insurance will tend to increase the level of capital required. If supervision detects risky behavior ex ante then it is complementary to capital regulation. However, financial innovation may erode supervisors' ability to detect risk and capital levels should then be higher. Regulators, however, may not be aware their capacities have been undermined. The paper argues for a four-prong policy response with higher bank capital ratios, enhanced supervision, limits to the use of complex financial instruments and Coco's. The results may support the institutional arrangements proposed recently in the United Kingdom.
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Bibliographic InfoPaper provided by Inter-American Development Bank in its series IDB Publications with number 67138.
Date of creation: Dec 2011
Date of revision:
Financial Sector; Financial Crises & Economic Stabilization; Bank management; Financial institutions; Banking law; Bank Regulation; Financial Crises;
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