Bank regulation in most countries encompasses a lender of last resort, deposit
insurance and supervision. These functions are interrelated and therefore
require coordination among the authorities responsible for them. These
authorities, however, are often established with different mandates, some of
which are likely to be in conflict. We consider these issues by studying the
optimal institutional allocation of such functions.
We find that a single regulator will lead to insufficient bank monitoring and
suboptimal bank investment in loans. It may also lead to too much forbearance.
We consider alternative structures to deal with the problem of excess
forbearance both in a full information setting and in settings with asymmetry of
information between regulators. We show in the former setting that if it is
feasible to prespecify the rates on lending of last resort, then it is useful to
make this function the exclusive province of one regulator. By giving the
deposit insurer the authority to close banks and by having last resort lending
insured, one gives the deposit insurer strong incentives against forbearance. If
it is not possible to pre-specify such rates, then a useful arrangement is to
have both the central bank and the deposit insurer acting as lenders of last
resort. In this structure it is important for the last resort lending to be
uninsured in order to reduce temptation to overlend, although this somewhat
increases the deposit insurer's temptation to forbear.
The final section of the paper analyses asymmetry of information between
regulators. We show that regulators may have an incentive not to share gathered
information. Since some regulators find it easier to collect particular
information, this result suggests that it is important to consider informational
advantages in the allocation of bank regulation.