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Prompt Corrective Action (PCA) is a system of predetermined capital/asset ratios that trigger supervisory actions by a banking regulator. Our paper addresses the optimality of this regulation system by dapting a dynamic model of entrepreneurial finance to banking regulation. In a dynamic moral hazard setting, we first derive the optimal contract between the banker and the regulator and then implement it by a menu of regulatory tools. Our main findings are the following: first, the insurance premium is a risk-based premium where the risk is measured by the capital level; second, our model implies a capital regulation system that shares several similarities with the US PCA. According to our proposed system, regulatory supervision should be realized in the spirit of gradual intervention and the book-value of capital is used as information to trigger intervention. Banks with high capital are not subject to any restrictions. Dividend distribution is prohibited in banks with intermediate level of capital. When banks have low capital level, a plan of recapitalization is required and in the worst case, banks are placed in liquidation.

Optimality of Prompt Corrective Action in a Continuous-Time Model with Recapitalization Possibility