Dynamic Prudential Regulation: Is Prompt Corrective Action Optimal?


  • I would like to thank Narayana Kocherlakota for his advice and Peter DeMarzo for his helpful discussions and suggestions. I am indebted to Deborah Lucas and Robert DeYoung (the Editors) and two anonymous referees for their comments and suggestions. I also thank Andrew Filardo, Robert Hall, Pete Klenow, Paul Kupiec, Esteban Rossi-Hansberg, Michele Tertilt, Kostas Tsatsaronis, Ke Wang, Mark Wright, James Yetman, and seminar participants at Stanford University, U-Tokyo, UBC, Simon Fraser University, UWO, U-Toronto, St. Louis Fed, KDI School, BIS, Richmond Fed, IMF, 2005 RES conference, and 2006 North American Summer Meetings of Econometric Society for comments. The views expressed herein are those of the author and not necessarily those of the Bank for International Settlements. All remaining errors are mine.


The current U.S. bank capital regulation features prompt corrective action, which mandates regulators to intervene in and liquidate banks based on their book-value capital ratios. To see if prompt corrective action is optimal, I build a dynamic model of repeated interactions between a banker and a regulator. Under hidden choice of risk, private information on returns and limited commitment by the banker, and costly liquidation, I first characterize the optimal incentive-feasible allocation. I 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 stochastic liquidation.