ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Collateral Monitoring and Banking Regulation

It is well recognised that in the event of massive defaults or significant accumulation of non-performing assets, the government or a super regulator such as the central bank bails out public sector banks. Banks usually ask for collateral to hedge against defaults. However, we argue that they might not be careful in monitoring the quality of collateral, particularly when they think that the success probability is reasonably high and they will be protected in case of defaults. Limited liability and the definite possibility of a bail out in case of a default can impose severe costs on the regulator who, due to political or social reasons, cannot shift the risk onto the depositors. This is very likely to happen in poor developing countries. We design an incentive mechanism for public sector banks that calls for auditing in the 'good states' of nature. The regulator does not need to regulate when the probability of success is very high or very low. But there is a range of probabilities for which private monitoring by banks falls short of optimal monitoring desired by the regulator. Our scheme helps to implement the desired outcome.

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