The Informational Impact of Prudential Regulations
62 Pages Posted: 12 Aug 2021 Last revised: 28 Apr 2023
Date Written: April 7, 2023
Banks take costly actions (such as higher capitalization, liquidity holding, and advanced risk management) to avoid financial distress and creditor runs. While such actions directly affect a bank’s risks, they can also signal its fundamentals. We show that prudential regulations have an informational impact: sufficiently tight regulations can eliminate inefficient separating equilibria in banks’ signaling game, thereby changing the information available to creditors and their incentives to run. When accounting for this informational impact, tightening regulations can improve banks’ payoffs and be considered bank incentive-compatible. We support this novel, information-based rationale for regulations with evidence from the US liquidity requirement.
Keywords: Prudential Regulations, Signaling, Bank Runs, Global Games
JEL Classification: G01, G11, G21
Suggested Citation: Suggested Citation