BFS 2002

Contributed Talk

Optimal Supervision and Depositor Preference Laws

Henri Pags, Joo Santos

When supervisors have imperfect information about the soundness of the banks they monitor, they may be unaware of insolvency problems that develop rapidly in the intervals between on-site examinations. This paper analyses the trade-offs that supervisors face between the cost of bank examination and the need to supervise banks effectively. We first characterize the optimal policy of an independent supervisor, both in terms of the frequency of examinations and of the target zones requiring action. We then extend our analysis by making bank supervisors accountable for deposit insurance losses. We find that, while depositor preference laws give supervisors an incentive to be stiffer with problem banks, these laws also lead supervisors to be more lenient with solvent banks, potentially leaving them with more opportunities to take risks.