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Banking Regulation without Commitment to Audit

Author

Listed:
  • Patrick Leoni

Abstract

We consider a regulator providing deposit insurance to a bank with private information about its investment portfolio. As typical in practice, we assume that the regulator does not commit to auditing after any risk report from the bank. We first show that the optimal contract can be implemented through a direct revelation mechanism. We also show that, at the optimal contract, a high risk bank has incentives to misreport. We thus establish that extraction of truthful risk information, as done in current regulatory practice, is not compatible with the maximization of social welfare.

Suggested Citation

  • Patrick Leoni, "undated". "Banking Regulation without Commitment to Audit," IEW - Working Papers 251, Institute for Empirical Research in Economics - University of Zurich.
    • Handle: RePEc:zur:iewwpx:251
    as

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    File URL: https://www.zora.uzh.ch/id/eprint/52141/1/iewwp251.pdf
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    References listed on IDEAS

    as
    1. Helmut Bester & Roland Strausz, "undated". "Imperfect Commitment and the Revelation Principle," Papers 004, Departmental Working Papers.
    2. Giammarino, Ronald M & Lewis, Tracy R & Sappington, David E M, 1993. "An Incentive Approach to Banking Regulation," Journal of Finance, American Finance Association, vol. 48(4), pages 1523-1542, September.
    3. Fahad Khalil, 1997. "Auditing Without Commitment," RAND Journal of Economics, The RAND Corporation, vol. 28(4), pages 629-640, Winter.
    4. Flannery, Mark J., 1991. "Pricing deposit insurance when the insurer measures bank risk with error," Journal of Banking & Finance, Elsevier, vol. 15(4-5), pages 975-998, September.
    5. Lucas, Deborah & McDonald, Robert L., 1987. "Bank portfolio choice with private information about loan quality : Theory and implications for regulation," Journal of Banking & Finance, Elsevier, vol. 11(3), pages 473-497, September.
    6. Chan, Yuk-Shee & Greenbaum, Stuart I & Thakor, Anjan V, 1992. "Is Fairly Priced Deposit Insurance Possible?," Journal of Finance, American Finance Association, vol. 47(1), pages 227-245, March.
    7. Ballard, Charles L & Shoven, John B & Whalley, John, 1985. "General Equilibrium Computations of the Marginal Welfare Costs of Taxes in the United States," American Economic Review, American Economic Association, vol. 75(1), pages 128-138, March.
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    JEL classification:

    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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