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.
Is Fairly Priced Deposit Insurance Possible
The authors analyze risk-sensitive, incentive-compatible deposit insurance in the presence of private information and moral hazard. Without deposit-linked subsidies, it is impossible to implement risk-sensitive, incentive-compatible deposit insurance pricing in a competitive, deregulated environment except when the deposit insurer is the least risk averse agent in the economy. The authors establish this formally in the context of an insurance scheme in which privately informed depository institutions are offered deposit insurance premia contingent on reported capital; the result holds for alternative sorting instruments as well. This suggests a contradiction between deregulation and fairly priced, risk-sensitive deposit insurance. Copyright 1992 by American Finance Association.