Dynamic prudential regulation: Is prompt corrective action optimal?

Ilhyock Shim

No 206, BIS Working Papers from Bank for International Settlements

Abstract: Prompt Corrective Action (PCA) prescribes prompt and deterministic termination of banks with insufficient levels of book-value capital. This paper investigates whether reliance on book-value capital is a good policy choice and if PCA is an optimal regulatory approach. I use a variant of DeMarzo and Fishman's (2004) dynamic model of entrepreneurial finance to model interactions between a banker and a regulator. Under hidden choice of risk, private information on returns, limited commitment by the banker and costly liquidation, I first characterize the optimal incentive-feasible allocation, and then demonstrate that the optimal allocation is implementable through the combination of a risk-based deposit insurance premium and a book-value capital regulation with prompt and stochastic termination/bailout rather than deterministic termination with no bailout as in PCA. I also show that partial termination can be used instead of stochastic termination.

Keywords: Bank Capital Regulation; Prompt Corrective Action; Risk-based Deposit Insurance Premium; Dynamic Contracts; Mechanism Design (search for similar items in EconPapers)
JEL-codes: D82 E58 G21 G28 (search for similar items in EconPapers)
Pages: 64 pages
Date: 2006-05
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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Related works:
Journal Article: Dynamic Prudential Regulation: Is Prompt Corrective Action Optimal? (2011)
Journal Article: Dynamic Prudential Regulation: Is Prompt Corrective Action Optimal? (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:bis:biswps:206

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