Academic journal article International Journal of Business

Regulatory Practices and the Impossibility to Extract Truthful Risk Information

Academic journal article International Journal of Business

Regulatory Practices and the Impossibility to Extract Truthful Risk Information

Article excerpt

I. INTRODUCTION

Accurate estimates of the risk exposure in the banking industry are critical to regulators. This information allows not only to set precautionary measures to protect the banking industry, but also at individual level to adjust for premia in return for services offered by the regulator such as deposit insurance. However, banks are notoriously reluctant to disclose such information. For instance, banks in financial distress have clear incentives to keep this information private since detection may trigger regulatory intervention leading to severe changes in financial strategies and possibly financial sanctions.

This adverse selection issue has been addressed by the Bank for International Settlement through the Basel Committee, in an attempt to standardize methods to extract such risk information. Starting in 1999, the Fisher II Working Group was mandated to address two issues: 1- the optimal design of a standardized report of portfolio risk, and 2- the design of incentives to extract truthful risk information (see B.I.S. (2004)).

In this paper, we argue that extraction of truthful risk information is most often not socially optimal because of a current regulatory practice, and we isolate conditions under which it is socially optimal to do so. The practice leading to such a situation is the deliberate avoidance to commit to detect and sanction fraudulent reports.

The motivations for the absence of commitment to audit and to sanction fraudulent reports are described in details later in this section, but they represent a common feature of modern regulatory practices. We show that, in the case of a regulator providing deposit insurance to a bank, the socially optimal contract induces a high-risk bank to lie with strictly positive probability in most cases. The only exception we find is when the auditing cost is prohibitive, in which case we show the regulator should optimally implement a truth-telling contract.

A. Heuristic Results and Intuition

We address the above issues in the context of a regulator providing deposit insurance to a bank. We construe this regulatory relationship as a principal-agent relationship. We model current practices where a regulator first sets capital requirements and deposit level, with the credible threat to retire the operating licence if such requirements are not met. The bank reinvests part of the proceeds into risky loans, whose risk level is private information to the bank.

The regulator requires a report about the risk level, and sets an insurance premium to cover for deposit insurance. Then, without prior commitment and after receiving the report, the regulator may decide to audit at a fixed cost. An audit reveals the actual risk taken by bank, and in case of misreport we assume that the regulator seizes control of the bank profits. The bank seeks to maximize the overall value of its shares, whereas the regulator seeks to maximize social welfare that includes the market value of the bank less the social cost of financial distress.

We first show that the optimal contract can be implemented through a direct mechanism, answering the question of the optimal design of risk report addressed by the BIS. This result is non-trivial because, in absence of commitment to audit, the standard Revelation Principle does not apply and direct truth-telling mechanisms are not always optimal. Bester and Strausz (2001) analyzes this issue in details; the basic insight of this paper is that, when there is no commitment on some actions in a general contractual setting, the knowledge of the true state of the world stemming from truthful revelation may lead to late choices detrimental to the agent. Therefore, truth-telling may not always be optimal and randomized messages--or equivalently non-direct mechanisms--may compensate for the future exploitation of any available information by the principal. In contrast, when the principal commits to every action, truth-telling cannot be exploited against the agent in a similar way without renegading on previous commitment. …

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