Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/209944 
Year of Publication: 
2009
Series/Report no.: 
Working Paper No. 2009/28
Publisher: 
Norges Bank, Oslo
Abstract: 
Prompt Corrective Action (PCA) is a system of predetermined capital/asset ratios that trigger supervisory actions by a banking regulator. Our paper addresses the optimality of this regulation system by adapting a dynamic model of entrepreneurial finance to banking regulation. In a dynamic moral hazard setting, we first derive the optimal contract between the banker and the regulator and then implement it by a menu of regulatory tools. Our main findings are the following: first, the insurance premium is a risk-based premium where the risk is measured by the capital level; second, our model implies a capital regulation system that shares several similarities with the US PCA. According to our proposed system, regulatory supervision should be realized in the spirit of gradual intervention and the book-value of capital is used as information to trigger intervention. Banks with high capital are not subject to any restrictions. Dividend distribution is prohibited in banks with intermediate level of capital. When banks have low capital level, a plan of recapitalization is required and in the worst case, banks are placed in liquidation.
Subjects: 
prompt corrective action
capital regulation
dynamic contracting
recapitalization
JEL: 
D82
G21
G28
Persistent Identifier of the first edition: 
ISBN: 
978-82-7553-534-2
Creative Commons License: 
cc-by-nc-nd Logo
Document Type: 
Working Paper
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