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State-Contingent Bank Regulation With Unobserved Actionas And Unobserved Characteristics

  • David A. Marshall

    ()

  • Edward Simpson Prescott

    ()

    (CEMFI, Centro de Estudios Monetarios y Financieros)

This paper studies bank regulation in the presence of deposit insurance, where banks have private information on their own ability and their investment strategy. Banks choose the mean and variance of their portfolio return. Regulators wish to control banks' risk choice, even though all agents are risk neutral and there are no deadweight costs of bank failure, because high risk adversely affects banks' ex ante incentives along other dimensions. Regulatory tools studied are capital requirements and return-contingent fines. Regulators can seek to separate bank types by offering a menu of contracts. We use numerical methods to study the properties of the model with two different bank types. Without fines, capital requirements only have limited ability to separate bank types. When fines are added, separation is much easier. Fine schedules and capital requirements are tailored to bank type. Low quality banks are fined when they produce high returns in order to control risk-taking behavior. High quality banks face fines on lower returns to prevent low-type banks from pretending they are high quality. Combining state-contingent fines with capital regulation significantly improves upon pure capital regulation.

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Paper provided by CEMFI in its series Working Papers with number wp2004_0407.

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Date of creation: Apr 2004
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Handle: RePEc:cmf:wpaper:wp2004_0407
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  1. Boyd, John H., 2001. "Bank capital regulation with and without state-contingent penalties A comment," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 54(1), pages 185-189, June.
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  5. David A. Marshall & Edward Simpson Prescott, 2000. "Bank capital regulation with and without state-contingent penalties," Working Paper Series WP-00-10, Federal Reserve Bank of Chicago.
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  12. John H. Boyd & Chun Chang & Bruce D. Smith, 1998. "Moral hazard under commercial and universal banking," Working Papers 585, Federal Reserve Bank of Minneapolis.
  13. Giammarino, R.M. & Sappington, D.E.M., 1990. "An Incentive Approach to Banking Regulation," Papers 367, California Davis - Institute of Governmental Affairs.
  14. Edward Simpson Prescott, 2004. "State-contingent bank regulation with unobserved actions and unobserved characteristics," Working Paper 04-02, Federal Reserve Bank of Richmond.
  15. Nagarajan, S. & Sealey, C. W., 1998. "State-contingent regulatory mechanisms and fairly priced deposit insurance," Journal of Banking & Finance, Elsevier, vol. 22(9), pages 1139-1156, September.
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  23. Lacker, Jeffrey M & Weinberg, John A, 1989. "Optimal Contracts under Costly State Falsification," Journal of Political Economy, University of Chicago Press, vol. 97(6), pages 1345-63, December.
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  25. Edward Simpson Prescott, 2003. "Communication in Private-Information Models: Theory and Computation," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 28(2), pages 105-130, December.
  26. Jean Tirole & Jean-Jaques Laffont, 1985. "Using Cost Observation to Regulate Firms," Working papers 368, Massachusetts Institute of Technology (MIT), Department of Economics.
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  31. Edward Simpson Prescott, 1999. "A primer on moral-hazard models," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 47-78.
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