Dynamic prudential regulation: Is prompt corrective action optimal?

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.

JEL classification: D82, E58, G21, G28

Keywords: Bank Capital Regulation, Prompt Corrective Action, Risk-based Deposit Insurance Premium, Dynamic Contracts, Mechanism Design