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Keywords:

  • D82;
  • E58;
  • G21;
  • G28
  • prompt corrective action;
  • risk-based deposit insurance premium;
  • dynamic contracts;
  • mechanism design

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.