State-contingent bank regulation with unobserved actions and unobserved characteristics

Optimal bank regulation is studied in a model where bank quality is private information and bank portfolio choice is subject to moral hazard. Regulators wish to control bank risk solely because high risk adversely affects a bank incentives to improve its mean return. Numerical methods are developed...

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Bibliographic Details
Published in:Journal of economic dynamics & control 2006-11, Vol.30 (11), p.2015-2049
Main Authors: Marshall, David A., Prescott, Edward Simpson
Format: Article
Language:English
Subjects:
Bank regulation
Banks
Capital
Economic incentives
Economic models
Hidden information
Information
Model testing
Moral hazard
Optimal contracting
Regulation of financial institutions
Risk
Risk aversion
Studies
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Summary:Optimal bank regulation is studied in a model where bank quality is private information and bank portfolio choice is subject to moral hazard. Regulators wish to control bank risk solely because high risk adversely affects a bank incentives to improve its mean return. Numerical methods are developed to study the model. Capital regulation alone has a limited ability to separate types. Including ex post fines achieve separation at lower cost, resulting in improved welfare. Low-quality banks are fined on high returns in order to control risk-taking. High-quality banks face fines on lower returns mainly to ensure truth-telling by low-quality banks. High-quality banks bear the full cost of regulation.
ISSN:0165-1889
1879-1743
DOI:10.1016/j.jedc.2005.07.001