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Regulator Reputation and Optimal Banking Competition Policy

Alan D. Morrison


We consider an economy in which banks increase social welfare by monitoring but where the verifiable part of banking income is stochastic. Banks abstract non-verifiable returns and this can render banking contracts unattractive to investors. The survival of the banking sector is ensured by a regulator who determines the rent, or charter value, which accrues to the holder of a banking license and who sets deposit insurance levels. High charter values encourage bankers to reduce the opacity of their activities and deposit insurance mitigates the effects upon depositors of perquisit consumption. We show that there is a tradeoff between increased charter value and reduced deposit insurance. Moreover, optimal competition levels are a decreasing function of regulator reputation.

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