Bank capital for market risk: a study in incentive compatible regulation
Traditionally, government regulation in the United States follows a straightforward command approach. The government states the desired activities of the regulated firm, the allowable actions, and the prohibited actions. The firm is punished if it violates these strictures. Regulatory economists have identified many problems with this approach. First, there is the problem of asymmetry in information: Regulations cannot be enforced if they require information from the firm that the regulator cannot elicit reliably and at reasonable cost.
The Pre-Commitment Approach in a Model of Regulatory Banking Capital
The pre-commitment approach offers a novel way to improve bank capital regulation. It requires that banks choose their capital levels and that regulators fine them if losses exceed this level. In essence, the approach is a proposal to use menus of contracts, a device commonly employed in other economic settings. Using a private-information model, the author derives optimal fine schedules and compares them to the proposal's schedules. He shows the latter schedules to be inefficient and potentially to require high levels of fines.
The Regulation of Bank Capital: Do Capital Standards Promote Bank Safety?
Abstract We show that in an imperfect information environment the equity value of an impaired bank may increase or decrease when it is required to meet a capital standard. Regardless of the change in the bank's equity value, however, its stock price will fall in response to a forced recapitalization, consistent with recent empirical evidence. Simulations of our model suggest that this stock price decline is likely to be larger the smaller is the share of ownership held by the managers of the bank, also consistent with recent empirical evidence in the literature. Our model further predicts a rise in bank's non-interest expenses following a required recapitalization. Given the increase in the regulator's exposure that would accompany a reduction in the bank's market value of equity, the regulator may choose not to enforce the regulation. Hence, capital regulation may be time-inconsistent in this situation and consequently not have its intended risk-mitigating incentives.