Banking Regulation and Prompt Corrective Action

37 Pages Posted: 30 Jun 2008

See all articles by Xavier Freixas

Xavier Freixas

Universitat Pompeu Fabra; Centre for Economic Policy Research (CEPR); Barcelona Graduate School of Economics (Barcelona GSE)

Bruno Maria Parigi

University of Padua - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: June 30, 2008

Abstract

We explore the rationale for regulatory rules that prohibit banks from developing some of their natural activities when their capital level is low, as epitomized by the U.S. Prompt Corrective Action (PCA). This paper is built on two insights. First, in a moral hazard setting, capital requirement regulation may force banks to hold a large fraction of safe assets which, in turn, may lower their incentives to spend effort in risky assets. Second, agency problems may be more severe in certain asset classes than in others. Taken together, these two ideas explain why, surprisingly, capital regulation, which may cope with risk and adverse selection, is unable to address issues related to moral hazard. Hence, instead of forcing banks to hold a large fraction of safe assets, prohibiting some types of investment and allowing ample scope of investment on others may be the only way to preserve incentives and guarantee funding. In particular, providing incentives to devote effort in the most opaque asset classes may prove to be excessively costly in terms of the required capital and thus inefficient. We show that the optimal capital regulation consists of a rule that a) allows well capitalized banks to freely invest any amount in any risky asset; b) prohibits banks with intermediate levels of capital to invest in the most opaque risky assets; and c) prohibits undercapitalized banks to invest in any risky asset. Furthermore we show that the implementation of these restrictions cannot be left to the discretion of the regulator as discretion will lead to forbearance thus weakening ex ante incentives. Thus, our paper provides a rationale for PCA and related regulatory rules that restrict activities of undercapitalized banks.

Keywords: banking, prudential regulation, moral hazard

JEL Classification: E58, G21

Suggested Citation

Freixas, Xavier and Parigi, Bruno Maria, Banking Regulation and Prompt Corrective Action (June 30, 2008). 21st Australasian Finance and Banking Conference 2008 Paper. Available at SSRN: https://ssrn.com/abstract=1153447 or http://dx.doi.org/10.2139/ssrn.1153447

Xavier Freixas

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas 25-27
Barcelona, 08005
Spain
+34 93 542 2726 (Phone)
+34 93 542 1746 (Fax)

HOME PAGE: http://www.econ.upf.es/~freixas

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

HOME PAGE: http://www.econ.upf.es/~freixas/more/personal1.htm

Barcelona Graduate School of Economics (Barcelona GSE) ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

Bruno Maria Parigi (Contact Author)

University of Padua - Department of Economics ( email )

via Del Santo 33
Padova, 35123
Italy

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

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