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Bank regulation and supervision: A symbiotic relationship

Author

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  • Agarwal, Isha
  • Goel, Tirupam

Abstract

Supervisory assessments such as stress-tests gauge banks’ riskiness and allow regulators to impose bank-specific capital regulation. This can improve welfare. Yet, regulation based on noisy supervision can decrease welfare by mis-classifying banks, distorting incentives, and crucially, leading to greater risk taking. Regulation should not be bank-specific in such cases. When bank defaults are costlier, supervision should strive for lower probability that riskier banks go undetected, i.e., reduce false-negatives even if this causes more false-positives. When the supervisor can incur a cost to optimally reduce both false-positive and false-negative rates, the regulator should make capital requirements more bank specific.

Suggested Citation

  • Agarwal, Isha & Goel, Tirupam, 2024. "Bank regulation and supervision: A symbiotic relationship," Journal of Banking & Finance, Elsevier, vol. 163(C).
    • Handle: RePEc:eee:jbfina:v:163:y:2024:i:c:s037842662400102x
    DOI: 10.1016/j.jbankfin.2024.107185
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    More about this item

    Keywords

    Capital regulation; Supervisory stress-tests; Information asymmetry; Adverse incentives; Optimal policy; Policy coordination;
    All these keywords.

    JEL classification:

    • 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
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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