Abstract
This paper examines the incentive compatible role of regulatory forbearance policy in the context of optimal bank regulation under moral hazard. We show that, when a bank's asset portfolio returns have market risk, the regulator can influence the bank's choice of ex ante risk by delaying the closure of an insolvent bank. The optimal closure policy involves co-ordinating the closure decision with market-wide performance. Such a policy may significantly alleviate the bank's ex ante risk-shifting problem. Furthermore, even fixed-rate deposit insurance can be optimal when combined with a sound forbearance policy and a minimum capital standard.
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