State-Contingent Bank Regulation with Unobserved Action and Unobserved Characteristics

64 Pages Posted: 27 Mar 2003

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: December 27, 2002

Abstract

This paper studies bank capital regulation under deposit insurance when bank attributes and actions are private information. Banks are heterogenous in quality and choose both the mean and variance of their investment strategy. Regulatory tools include capital regulation and state-contingent fines. 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. Generally, low quality banks face a higher capital requirement and pay lower fines than high quality banks. Utility of low quality banks increases and utility of high quality banks decreases relative to the case where bank type is public information. Often, randomization is incorporated in the optimal policy. In addition, truth-telling constraints may bind in both directions.

Suggested Citation

Marshall, David Aaron and Prescott, Edward (Ned) Simpson, State-Contingent Bank Regulation with Unobserved Action and Unobserved Characteristics (December 27, 2002). FRB of Chicago Working Paper No. 2002-24. Available at SSRN: https://ssrn.com/abstract=367181 or http://dx.doi.org/10.2139/ssrn.367181

David Aaron Marshall (Contact Author)

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604-1413
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University of Chicago - Booth School of Business ( email )

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Edward (Ned) Simpson Prescott

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

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Cleveland, OH 44101
United States

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

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