State-Contingent Bank Regulation

Abstract

Current legislation attempts to solve incentive problems in bank regulation, by instituting polices such as risk-adjusted deposit insurance premiums, strict capital requirements, prompt closure policies, etc. Recent theoretical works have shown such policies to be neither necessary nor sufficient, per se, to solve these problems. In this paper, we present a model of incentive compatible bank regulation under moral hazard and adverse selection. We derive a wide range of simple mechanisms that can solve both types of incentive problems and also achieve first-best outcomes, but only when the regulatory instruments involve ex post pricing base don’t eh performance of the bank relative to the market. An important implication of the model is that these mechanisms need not involve a subsidy to the bank.