Abstract
This paper adopts a dynamic contracting framework to study the design of prudential regulation of a bank engaging in excessive risk-taking. The bank's manager can enhance short term profits by either exerting effort or taking on excessive risk, which increases the bank's exposure to tail risk. Without capital requirements, shareholders induce the manager to undertake excessive risk when the bank is undercapitalised and the regulator grants forbearance ex-post. The socially optimal regulation curbs excessive risks through a capital requirement, forcing shareholders to recapitalise the bank before entering financial distress.The capital requirement possesses bank's specific attributes, being stricter for institutions with higher exposure to systemic risk and stronger agency problems. Alternatively, temporarily dismissing the manager allows the bank to recover from financial distress avoiding excessive risk-taking.
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