The role of regulatory credibility in effective bank regulation

Ephraim Clark and Octave Jokung-Nguena
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Octave Jokung-Nguena: IDP - Institut du Développement et de la Prospective - EA 1384 - UVHC - Université de Valenciennes et du Hainaut-Cambrésis - IAE - Institut d'Administration des Entreprises - UPHF - Université Polytechnique Hauts-de-France

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Abstract: This paper develops a model of regulated Brownian motion with an endogenous profit term to analyze the role of regulatory credibility on the stability and productivity of the banking system. We show that when regulatory intervention is perfect and costless, the volatility of the system can be substantially reduced with no loss of productivity. In fact, perfect credibility can actually reduce the volatility of intrinsically risky banking systems below the volatility of intrinsically less risky systems as banks anticipate intervention and mitigate their investment behaviour accordingly. However, when the credibility of the regime is weakened because of increased uncertainty stemming from regulation, such as random costs or imperfect timing of regulatory intervention, both the stability and productivity of the financial system are impaired. Importantly, we find that in the presence of regulatory costs and imperfect credibility, there is no universal optimal intervention policy rule. The optimal regulatory system depends on the regulator's level of absolute risk aversion.

Keywords: Systemic risk; Micro-prudential regulation; Procyclicality; Regulated Brownian motion; Endogenous expectations (search for similar items in EconPapers)
Date: 2015-01
Note: View the original document on HAL open archive server: https://uphf.hal.science/hal-03003034v1
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Citations: View citations in EconPapers (2)

Published in Journal of Banking and Finance, 2015, 50, pp.506-513. ⟨10.1016/j.jbankfin.2014.03.018⟩

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Journal Article: The role of regulatory credibility in effective bank regulation (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-03003034

DOI: 10.1016/j.jbankfin.2014.03.018

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