Good and Bad Risk: Regulation and Loan Monitoring

11 Pages Posted: 17 Apr 2018

See all articles by Norvald Instefjord

Norvald Instefjord

University of Essex - Essex Business School

Hiroyuki Nakata

University of Tokyo - Faculty of Economics

Date Written: February 7, 2018

Abstract

Separating good and bad borrowers is a key role of banks. To do this, banks need monitoring systems and they need to monitor risky loans. We show that the investment in monitoring systems encourages risk taking, which leads to higher regulatory costs for the bank. This effect is so strong that it not only discourages investment in monitoring systems, but also banks can profitably dismantle their existing systems, because the savings in terms of regulatory compliance costs are greater than what they lose to less efficient loan monitoring. A bank regulator who controls bank risk in an indiscriminate way, therefore, can distort the loan-monitoring activity of banks, which can be harmful to the cost of loans. A more sophisticated approach, where the regulator discriminates between the good risk that arises from loan-monitoring activity and the bad risk that arises in other contexts, can mitigate this effect.

Suggested Citation

Instefjord, Norvald and Nakata, Hiroyuki, Good and Bad Risk: Regulation and Loan Monitoring (February 7, 2018). Journal of Financial Perspectives, Vol. 5, No. 1, 2018, Available at SSRN: https://ssrn.com/abstract=3154383

Norvald Instefjord (Contact Author)

University of Essex - Essex Business School ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

Hiroyuki Nakata

University of Tokyo - Faculty of Economics ( email )

7-3-1 Hongo, Bunkyo-ku
Tokyo 113-0033
Japan

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