Abstract
Regulating bank risk-taking is challenging since banks know more than regulators about the risks of their portfolios and can make adjustments to game regulations. To address this problem, I build a tractable model that incorporates this information asymmetry. The model is flexible enough to encompass many regulatory tools, although I focus on taxes. These taxes could also be interpreted as reflecting the shadow costs of other regulations, such as capital requirements. I show that linear risk-sensitive taxes should not generally be set more conservatively to address asymmetric information. I further show the efficacy of three regulatory tools: (1) not disclosing taxes to banks until after portfolio selection, (2) nonlinear taxes that respond to information contained in banks' portfolio choice, and (3) taxes on banks' realized profits that incentivize banks to reduce risk.
Published Version
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