The role of regulatory credibility in effective bank regulation

Clark, Ephraim A. and Jokung, Octave (2015) The role of regulatory credibility in effective bank regulation. Journal of Banking & Finance, 50 . pp. 506-513. ISSN 0378-4266 (doi:10.1016/j.jbankfin.2014.03.018)

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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.

Item Type: Article
Additional Information: Available online 20 March 2014
Keywords (uncontrolled): Systemic risk; Micro-prudential regulation; Procyclicality; Regulated Brownian motion; Endogenous expectations
Research Areas: A. > Business School > Accounting and Finance
Item ID: 17103
Notes on copyright: © 2014 The Authors. Published by Elsevier B.V. This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/3.0/).
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Depositing User: Sasha Antoni
Date Deposited: 29 Jun 2015 08:57
Last Modified: 02 Jun 2019 05:11
URI: https://eprints.mdx.ac.uk/id/eprint/17103

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