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Optimality of prompt corrective action in a continuous - time model with recapitalization possibility

Listed author(s):
  • Vo Thi Quynh Anh

    (Norges Bank (Central Bank of Norway))

Registered author(s):

    Prompt Corrective Action (PCA) is a system of predetermined capital/asset ratios that trigger supervisory actions by a banking regulator. Our paper addresses the optimality of this regulation system by dapting a dynamic model of entrepreneurial finance to banking regulation. In a dynamic moral hazard setting, we first derive the optimal contract between the banker and the regulator and then implement it by a menu of regulatory tools. Our main findings are the following: first, the insurance premium is a risk-based premium where the risk is measured by the capital level; second, our model implies a capital regulation system that shares several similarities with the US PCA. According to our proposed system, regulatory supervision should be realized in the spirit of gradual intervention and the book-value of capital is used as information to trigger intervention. Banks with high capital are not subject to any restrictions. Dividend distribution is prohibited in banks with intermediate level of capital. When banks have low capital level, a plan of recapitalization is required and in the worst case, banks are placed in liquidation.

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    File URL: http://www.norges-bank.no/en/Published/Papers/Working-Papers/2009/WP-200928/
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    Paper provided by Norges Bank in its series Working Paper with number 2009/28.

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    Length: 24 pages
    Date of creation: 01 Dec 2009
    Handle: RePEc:bno:worpap:2009_28
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    1. Xavier Freixas & Bruno Maria Parigi, 2007. "Banking Regulation and Prompt Corrective Action," CESifo Working Paper Series 2136, CESifo Group Munich.
    2. PETER M. DeMARZO & YULIY SANNIKOV, 2006. "Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model," Journal of Finance, American Finance Association, vol. 61(6), pages 2681-2724, December.
    3. Bruno Biais & Thomas Mariotti & Guillaume Plantin & Jean-Charles Rochet, 2007. "Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications," Review of Economic Studies, Oxford University Press, vol. 74(2), pages 345-390.
    4. Barth, James R. & Caprio, Gerard Jr. & Levine, Ross, 2004. "Bank regulation and supervision: what works best?," Journal of Financial Intermediation, Elsevier, vol. 13(2), pages 205-248, April.
    5. Ilhyock Shim, 2011. "Dynamic Prudential Regulation: Is Prompt Corrective Action Optimal?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(8), pages 1625-1661, December.
    6. Peter M. DeMarzo & Michael J. Fishman, 2007. "Agency and Optimal Investment Dynamics," Review of Financial Studies, Society for Financial Studies, vol. 20(1), pages 151-188, January.
    7. Kim, Daesik & Santomero, Anthony M, 1988. " Risk in Banking and Capital Regulation," Journal of Finance, American Finance Association, vol. 43(5), pages 1219-1233, December.
    8. Guillaume Plantin & Bruno Biais & Thomas Mariotti & Jean-Charles Rochet, 2004. "Dynamic Security Design," GSIA Working Papers 2005-E5, Carnegie Mellon University, Tepper School of Business.
    9. Gian Luca Clementi & Hugo A. Hopenhayn, 2006. "A Theory of Financing Constraints and Firm Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 121(1), pages 229-265.
    10. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, January.
    11. George J. Benston & George G. Kaufman, 1997. "FDICIA after Five Years," Journal of Economic Perspectives, American Economic Association, vol. 11(3), pages 139-158, Summer.
    12. Mathias Dewatripont & Jean Tirole, 1993. "La réglementation prudentielle des banques," ULB Institutional Repository 2013/9537, ULB -- Universite Libre de Bruxelles.
    13. Yuliy Sannikov, 2008. "A Continuous-Time Version of the Principal-Agent Problem," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 957-984.
    14. João A. C. Santos, 2000. "Bank capital regulation in contemporary banking theory: a review of the literature," BIS Working Papers 90, Bank for International Settlements.
    15. 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, vol. 25(6), pages 1139-1160, June.
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