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Rules vs. Discretion in Times of Financial Liberalization

How banks should be regulated in periods of intense financial innovation? Is traditional risk-weighted capital regulation sufficient or should we consider regulatory interference in the form of restrictions to the scope of bank's activities? To enforce regulations should we rely discretion or should we impose rules that constrain the regulators? These questions are motivated on the one hand by the severe governance problems that arise because of the power of bankers and, on the other hand, by the risk of supervisory forebearance. These questions are particularly important in periods of changing economic environment and financial innovations which tend to make banks' investment more opaque. To answer these questions, we develop a model where banks investment decision is non-contratible, with the option to limit their effort and engage in an inferior investment project. We show, first, that scope restrictions like the Prompt Corrective Action (PCA) regulation introduced by FDICIA in the US in 1991 is of interest only when banks engage in opaque projects in the presence of moral hazard. Second we show how capital regulation may erode the managers rents and deprive them of a sufficient incentive to monitor their project. Finally we show under what conditions there is an advantage to make scope restrictions compulsory, even if the regulators' objective function is unbiased, and this is because ex post the regulator prefers to implement a bail-out policy that might provide the bank manager with the wrong incentives ex ante. So, mandatory vs. discretionary scope restrictions depends upon how important are the ex ante moral hazard effects of the ex post bail-out policy.