The Regulator’s trade-off: Bank Supervision vs. Minimum Capital by Florian Buck and Eva Schliephake Discussion: Fabio Castiglionesi Department of Finance Tilburg University Macro-prudential Regulation Workshop November 29 th, 2012 – Olso, Norges Bank

2 Aim of the Paper To disentangle the trade-off between capital requirements (more regulated) and bank supervision (left to national authorities) To analyze a broader approach to regulation (“political economy” vs. prudential regulation)

3 General Assessment The paper addresses a relevant topic: Which policy tool (or which mix of them) guarantees a stable banking system? The effort to understand it focusing on a broad approach is worth it. But the paper should be more consistent between the different parts.

4 Mechanism I Optimal regulation in a closed economy. Adverse Selection: some banks θ have access to a monitoring technology. Moral Hazard in efficient banks. Capital requirement solves MH (but not AS), supervision (affecting fraction θ) solves AS.

5 Mechanism II Optimal regulation in open economies. The optimal mix depends on the observability of the banking sector’s national regulation. If it is observable, then the optimal mix is possible. Otherwise, a deregulation race occurs and autarky is preferred.

6 Comments (I) The adverse selection problem needs more clarification. The opaqueness of the banking system is extreme. Depositors do not observe bank’s type but why they cannot observe any choice variable (like additional capital, profits, leverage)? Argue convincingly that traditional screening mechanisms do not solve the AS problem (or that are worse than regulatory allocation).

7 Comments (II) In the model, a signaling device could be the interest rate paid on deposits. Assumption of perfect competition assures this interest rate taken as given. If banks can capture the regulator (as in the supervision analysis), why not change the nature of deposits market? Efficient banks could signal their type by increasing interest rate. Goofy banks will not follow. AS could be solved?

8 Comments (III) The paper considers the type of the bank θ as a primitive (state of the world) of the model. However, the regulator can transform the type by supervising the bank. To be consistent, why not consider the type of the bank as a choice in the previous analysis as well?

9 Comments (IV) In the optimal policy not clear why profits of the goofy banks are not considered by the regulators in its objective function. They are inefficient banks but they are still in the economy. What is the rationale for not including them?

10 Comments (V) Suggestion: bring to the data the result that supervision and capital regulation are substitute. Higher supervision (higher θ*) implies lower k*. Less stringent capital regulation should be related to more stable banking system. k* varies in the cross-section and in the time series.

11 Comments (VI) Open economies. Assumption: depositors cannot distinguish different national regulatory regimes. Difficult to understand without further explanation. In the model we have a unique optimal pair (k*,θ*). Observing k*, you know θ* and therefore bank’s quality and charge the appropriate different interest rate. What I am missing?

12 Minor Comments (page 4): “non-monitoring project have negative expected returns”. Actually, it can still be the case that γ>Rp(L)>1. (page 5). The justifications for the costly bank capital assumption are weak (“private benefits for depositing”). Suggestion: make the assumption and move on.

13 Minor Comments The conditions on Definition 1 (θ sufficiently low for intermediation breakdown) and Lemma 1 (θ sufficiently high for capital to solve moral hazard problem) are consistent? Paper refer to rents about profits of the efficient banks, and profits about profits of the goofy banks. Why so?

14 Conclusions The paper addresses a very important issue. Improve the overall model’s consistency.

15 Thank you for your attention!