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State-contingent bank regulation with unobserved action and unobserved characteristics

  • David A. Marshall
  • Edward Simpson Prescott

This paper studies bank capital regulation under deposit insurance when bank attributes and actions are private information. Banks are heterogeneous in quality and choose both the mean and variance of their investment strategy. Regulatory tools include capital regulation and state-contingent fines. 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. Generally, low quality banks face a higher capital requirement and pay lower fines than high quality banks. Utility of low quality banks increases and utility of high quality banks decreases relative to the case where bank type is public information. Often, randomization is incorporated in the optimal policy. In addition, truth-telling constraints may bind in both directions

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-02-24.

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Date of creation: 2002
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Handle: RePEc:fip:fedhwp:wp-02-24
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  1. Edward Simpson Prescott, 2004. "Auditing And Bank Capital Regulation," Working Papers wp2004_0412, CEMFI.
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  14. Matutes, Carmen & Vives, Xavier, 2000. "Imperfect competition, risk taking, and regulation in banking," European Economic Review, Elsevier, vol. 44(1), pages 1-34, January.
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  25. Paul H. Kupiec & James M. O'Brien, 1995. "Recent developments in bank capital regulation of market risks," Finance and Economics Discussion Series 95-51, Board of Governors of the Federal Reserve System (U.S.).
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