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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. David A. Marshall & Edward S. Prescott, 2000. "Bank capital regulation with and without state-contingent penalties," Working Paper Series WP-00-10, Federal Reserve Bank of Chicago.
  2. Stephen F. LeRoy, 1990. "Mutual deposit insurance," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue jun8.
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  13. Laffont, Jean-Jacques & Tirole, Jean, 1986. "Using Cost Observation to Regulate Firms," Journal of Political Economy, University of Chicago Press, vol. 94(3), pages 614-41, June.
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  18. Edward Simpson Prescott, 2004. "State-contingent bank regulation with unobserved actions and unobserved characteristics," Working Paper 04-02, Federal Reserve Bank of Richmond.
  19. Paul H. Kupiec & James M. O'Brien, 1995. "A pre-commitment approach to capital requirements for market risk," Finance and Economics Discussion Series 95-36, Board of Governors of the Federal Reserve System (U.S.).
  20. 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.
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  25. Prescott, Edward C & Townsend, Robert M, 1984. "Pareto Optima and Competitive Equilibria with Adverse Selection and Moral Hazard," Econometrica, Econometric Society, vol. 52(1), pages 21-45, January.
  26. Besanko, David & Kanatas, George, 1996. "The Regulation of Bank Capital: Do Capital Standards Promote Bank Safety?," Journal of Financial Intermediation, Elsevier, vol. 5(2), pages 160-183, April.
  27. 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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  31. Green, Richard C., 1984. "Investment incentives, debt, and warrants," Journal of Financial Economics, Elsevier, vol. 13(1), pages 115-136, March.
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