Bank regulation and supervision: A symbiotic relationship

Abstract

Supervisory assessments such as stress-tests gauge banks’ riskiness and allow regulators to impose bank-specific capital regulation. This can improve welfare. Yet, regulation based on noisy supervision can decrease welfare by mis-classifying banks, distorting incentives, and crucially, leading to greater risk taking. Regulation should not be bank-specific in such cases. When bank defaults are costlier, supervision should strive for lower probability that riskier banks go undetected, i.e., reduce false-negatives even if this causes more false-positives. When the supervisor can incur a cost to optimally reduce both false-positive and false-negative rates, the regulator should make capital requirements more bank specific.