Bank capital regulation and secondary markets for bank assets
The paper derives optimal capital requirements, when the bank’s quality is private information. The supervisor can inspect the bank and punish the undercapitalized one with recapitalization and downsizing. The cost of bank’s capital and its ability to sell its assets are crucial for the bank’s incentive to reveal its quality truthfully. The paper provides following policy implications. First, sensitivity of capital requirements to the bank’s quality should be low in good times and high in bad times. Second, a leverage ratio should be accompanied by a requirement that the bank selling its assets retains part of them. Third, using results from supervisory inspection on the secondary market for the bank’s assets increases the bank’s incentive to misreport its quality. Fourth, implementation of the sensitive capital requirements cannot rely solely on information revealed on the market for the bank’s assets.
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