Good and Bad Risk: Regulation and Loan Monitoring
11 Pages Posted: 17 Apr 2018
Date Written: February 7, 2018
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.
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