Designing Incentive-Compatible Regulation in Banking: The Role of Penalty in the Precommitment Approach

The purpose of this paper is to present a framework forincentive-compatible regulation that would enable regulatorsto ensure that riskier banks maintain higher capitalholdings.Under the precommitment approach, a bankannounces the appropriate level of capital that covers themaximum value of expected loss that might arise in itstrading account. If the actual loss (after a certain period)exceeds the announced value, the bank is penalised. Thisframework creates the correct incentive for banks: Thebanks choose the level of capital that minimises the totalcost, which consists of the expected cost of penalty and thecost of raising capital.[...]