State-Contingent Bank Regulation with Unobserved Actions and Unobserved Characteristics

36 Pages Posted: 4 Dec 2012

See all articles by David A. Marshall

David A. Marshall

Federal Reserve Bank of Chicago; University of Chicago - Booth School of Business

Edward S. Prescott

Federal Reserve Banks - Federal Reserve Bank of Cleveland

Date Written: February 21, 2004

Abstract

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.

Keywords: bank regulation, moral hazard, hidden information

JEL Classification: D82, G21, G28

Suggested Citation

Marshall, David Aaron and Prescott, Edward (Ned) Simpson, State-Contingent Bank Regulation with Unobserved Actions and Unobserved Characteristics (February 21, 2004). FRB Richmond Working Paper No. 04-02. Available at SSRN: https://ssrn.com/abstract=2184951 or http://dx.doi.org/10.2139/ssrn.2184951

David Aaron Marshall (Contact Author)

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604-1413
United States
312-322-5111 (Phone)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Edward (Ned) Simpson Prescott

Federal Reserve Banks - Federal Reserve Bank of Cleveland ( email )

P.O. Box 6387
Cleveland, OH 44101
United States

HOME PAGE: http://https://www.clevelandfed.org/people-search?pid=f8ca941e-4b51-41f6-95f8-c87f1d3806e5

Register to save articles to
your library

Register

Paper statistics

Downloads
15
Abstract Views
385
PlumX Metrics