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Dynamic Prudential Regulation: Is Prompt Corrective Action Optimal?
Author(s) -
SHIM ILHYOCK
Publication year - 2011
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/j.1538-4616.2011.00461.x
Subject(s) - incentive , prudential regulation , capital requirement , value (mathematics) , microeconomics , deposit insurance , private information retrieval , action (physics) , capital (architecture) , economics , bank regulation , information asymmetry , regulator , incentive compatibility , business , actuarial science , monetary economics , finance , computer science , financial crisis , computer security , macroeconomics , history , biochemistry , chemistry , physics , quantum mechanics , gene , archaeology , machine learning
The current U.S. bank capital regulation features prompt corrective action, which mandates regulators to intervene in and liquidate banks based on their book‐value capital ratios. To see if prompt corrective action is optimal, I build a dynamic model of repeated interactions between a banker and a regulator. Under hidden choice of risk, private information on returns and limited commitment by the banker, and costly liquidation, I first characterize the optimal incentive‐feasible allocation. I then demonstrate that the optimal allocation is implementable through the combination of a risk‐based deposit insurance premium and a book‐value capital regulation with stochastic liquidation.