Agency Conflicts, Bank Capital Regulation, and Marking-to-Market

Abstract

ABSTRACT We show how shareholder-debtholder agency conflicts interact with strategic reporting under asymmetric information to influence bank regulation. Relative to a benchmark unregulated economy, higher capital requirements mitigate inefficient asset substitution, but potentially exacerbate underinvestment due to debt overhang. The optimal regulatory policy balances distortions created by agency conflicts and asymmetric information while incorporating the social benefit of bank debt. Asymmetric information and strategic reporting only impact regulation for intermediate social debt benefit levels. For lower social debt benefits in this interval, regulatory capital requirements are insensitive to accounting reports, so bank balance sheets need not be marked to market to implement the optimal regulatory policy. For higher social debt benefits, however, capital requirements are sensitive to accounting reports, thereby necessitating mark-to-market accounting to implement bank regulation. Mark-to-market accounting is essential when bank leverage levels are high, and is more likely to be necessary as banks' asset risk or specificity increases.