Rules vs. Discretion in Times of Financial Liberalization

41 Pages Posted: 16 Feb 2009

See all articles by Bruno Maria Parigi

Bruno Maria Parigi

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

Xavier Freixas

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

Date Written: February 14, 2009

Abstract

How banks should be regulated in periods of intense financial innovation? Is traditional risk-weighted capital regulation sufficient or should we consider regulatory interference in the form of restrictions to the scope of bank's activities? To enforce regulations should we rely discretion or should we impose rules that constrain the regulators? These questions are motivated on the one hand by the severe governance problems that arise because of the power of bankers and, on the other hand, by the risk of supervisory forebearance. These questions are particularly important in periods of changing economic environment and financial innovations which tend to make banks' investment more opaque. To answer these questions, we develop a model where banks investment decision is non-contratible, with the option to limit their effort and engage in an inferior investment project. We show, first, that scope restrictions like the Prompt Corrective Action (PCA) regulation introduced by FDICIA in the US in 1991 is of interest only when banks engage in opaque projects in the presence of moral hazard. Second we show how capital regulation may erode the managers rents and deprive them of a sufficient incentive to monitor their project. Finally we show under what conditions there is an advantage to make scope restrictions compulsory, even if the regulators' objective function is unbiased, and this is because ex post the regulator prefers to implement a bail-out policy that might provide the bank manager with the wrong incentives ex ante. So, mandatory vs. discretionary scope restrictions depends upon how important are the ex ante moral hazard effects of the ex post bail-out policy.

Keywords: banking regulation, moral hazard, propmpt corrective actions

JEL Classification: E58, G28.

Suggested Citation

Parigi, Bruno Maria and Freixas, Xavier, Rules vs. Discretion in Times of Financial Liberalization (February 14, 2009). Available at SSRN: https://ssrn.com/abstract=1342982 or http://dx.doi.org/10.2139/ssrn.1342982

Bruno Maria Parigi

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

Xavier Freixas (Contact Author)

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

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