Bank regulation and supervision: A symbiotic relationship

Isha Agarwal and Tirupam Goel

Journal of Banking & Finance, 2024, vol. 163, issue C

Abstract: Supervisory assessments such as stress-tests gauge banks’ riskiness and allow regulators to impose bank-specific capital regulation. This can improve welfare. Yet, regulation based on noisy supervision can decrease welfare by mis-classifying banks, distorting incentives, and crucially, leading to greater risk taking. Regulation should not be bank-specific in such cases. When bank defaults are costlier, supervision should strive for lower probability that riskier banks go undetected, i.e., reduce false-negatives even if this causes more false-positives. When the supervisor can incur a cost to optimally reduce both false-positive and false-negative rates, the regulator should make capital requirements more bank specific.

Keywords: Capital regulation; Supervisory stress-tests; Information asymmetry; Adverse incentives; Optimal policy; Policy coordination (search for similar items in EconPapers)
JEL-codes: C61 G21 G28 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:163:y:2024:i:c:s037842662400102x

DOI: 10.1016/j.jbankfin.2024.107185

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