Optimal Supervisory Policies and Depositor-Preference Laws

Abstract

When supervisors have imperfect information about the soundness of banks, they may be unaware of insolvency problems that develop in the interval between on-site examinations. Supervising banks more often will alleviate this problem but will increase the costs of supervision. This paper analyzes the trade-offs that supervisors face between the cost of supervision and their need to monitor banks effectively. We first characterize the optimal supervisory policy, in terms of the time between examinations and the closure rule at examinations, and compare it with the policy of an independent supervisor. We then show that making this supervisor accountable for deposit insurance losses in general reduces the excessive forbearance of the independent supervisor and may also improve on the time between examinations. Finally, we extend our analysis to the impact of depositor-preference laws on supervisors' monitoring incentives and show that these laws may lead to conflicting effects on the time between examinations and closure policy vis-a-vis the social optimum.