Risk-Insensitive Regulation

Banking is risky and prone to failure. Yet banking regulation is surprisingly not all that risk-sensitive in practice. I show that when the bank has an informational advantage over the regulator, designing risk-sensitive banking regulation gives rise to a trade-off: relying on the banking market for information to refine regulation improves bank risk-taking but also aggravates the market's allocative failure and could undermine its informativeness. This tension could explain why Basel capital regulations and deposit insurance are often coarse or risk-insensitive. Paradoxically, as market frictions become more severe, optimal regulation becomes ever more risk-insensitive. Only risk-insensitive regulation necessitates a system-wide approach