Concealment of risk and regulation of bank risk taking

This paper analyzes the effectiveness of banking regulation when risk can be concealed from the regulator. Three banking regimes are considered: regulation with direct controls, incentives-based regulation, and laissez-faire banking. The relative performance of the three regimes depends on the effectiveness of monitoring. Regulation with direct controls is superior when monitoring effectiveness is low, while incentives-based regulation is superior when monitoring effectiveness is high. Laissez-faire banking is equivalent to incentives-based regulation if market analysts and the regulator have access to the same information. When monitoring effectiveness is low, a regulator with direct controls can better restrain banks' risk taking than can the market; this result applies when banks can conceal much of their risk from the regulator.