Banking Regulation without Commitment to Audit

Patrick Leoni ()

No 251, IEW - Working Papers from Institute for Empirical Research in Economics - University of Zurich

Abstract: We consider a regulator providing deposit insurance to a bank with private information about its investment portfolio. As typical in practice, we assume that the regulator does not commit to auditing after any risk report from the bank. We first show that the optimal contract can be implemented through a direct revelation mechanism. We also show that, at the optimal contract, a high risk bank has incentives to misreport. We thus establish that extraction of truthful risk information, as done in current regulatory practice, is not compatible with the maximization of social welfare.

Keywords: Banking Regulation; Partial Commitment; Asymmetric Information; Adverse Selection (search for similar items in EconPapers)
JEL-codes: G28 (search for similar items in EconPapers)
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