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State-contingent bank regulation with unobserved actions and unobserved characteristics

Listed author(s):
  • Edward Simpson Prescott

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 Federal Reserve Bank of Richmond in its series Working Paper with number 04-02.

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Date of creation: 2004
Handle: RePEc:fip:fedrwp:04-02
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  12. 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.
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  15. Palomino, Frederic & Prat, Andrea, 2003. " Risk Taking and Optimal Contracts for Money Managers," RAND Journal of Economics, The RAND Corporation, vol. 34(1), pages 113-137, Spring.
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  17. Edward Simpson Prescott, 2004. "State-contingent bank regulation with unobserved actions and unobserved characteristics," Working Paper 04-02, Federal Reserve Bank of Richmond.
  18. Stephen F. LeRoy, 1990. "Mutual deposit insurance," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue jun8.
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  31. repec:cmf:wpaper:wp2004_0412 is not listed on IDEAS
  32. 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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